Last week, the Federal Reserve surprised investors by making no changes to its $85 billion-a-month bond-buying program. Investors had expected the Fed to reduce (taper) its purchases in September. According to the Fed, “The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market. The [Fed] decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.”
The Fed has been projecting stronger economic growth for a while. Yet the economy has struggled to generate moderate growth. The concern over growth manifested itself in the Fed’s decision to lower its growth projection to just over 2 percent this year. Growth rates of 2 percent are viewed as too slow for a healthy economy.
The lack of change constituted a surprise to markets. According to the Wall Street Journal shows, economists who thought tapering would begin outnumbered those who didn’t by 2 – 1. The percentage anticipating tapering had been rising steadily, so investors were definitely caught off guard.
In some ways, investor expectations were self-defeating because higher rates became a concern to the Fed. As more investors anticipated a reduction in the bond buying program, rates rose. On Wednesday, Federal Reserve Chairman Ben Bernanke cited higher interest rates as a threat to the recovery and a reason for delaying reductions in the bond-buying program.
Initial reaction to the surprise move was very positive for the market, but often negative by investment managers commenting on the decision. U.S. Treasury bonds rallied more than any time period since late 2011. Gold futures jumped 4.5 percent, and the S&P 500 leapt 1.2 percent to a new record. PIMCO’s Mohammed El-Erian said, “The real economy is a different issue, but the markets love it.”
Negative reactions to the decision were particularly strong. Albert Edwards from Societé General said, “Personally I am incredulous. I can believe the arch dove Bernanke might have wanted to keep blowing his bubbles, but I am amazed that he got the rest of the Fed, or at least the majority, on his side. I am also amazed because the Fed has spent weeks setting the markets up for a taper.” Later, he compared Bernanke to Rudolf von Havenstein, who was head of the Reichsbank during German hyperinflation after World War I.
Kansas City Fed President Esther George, the lone dissenter on the Fed’s Open Market Committee, said the Fed created confusion in the market and it risks credibility by delaying the reduction of its bond buying program. Stanley Druckenmiller, the founder of Duquense Capital, derisively added, “This is fantastic for every rich person. This is the biggest redistribution of wealth from the middle class and the poor to the rich ever.”
What does all this back and forth mean for CLS investors? First, one of CLS’s themes this year is “creative diversification.” Client portfolios have been balanced between securities that offer some yield while being less interest rate sensitive. Allocations to floating rate bonds and short-term debt, including treasuries, investment grade bonds, and high yield, have maintained some yield while lowering interest rate sensitivity.
Lately, investors have been concerned about any bond exposure. Requests for cash instead of bonds are on the rise. Before making a request to exit bonds, we believe investors should pause. As has been mentioned previously in our weekly reviews, bonds can still outperform cash if rates rise slowly. A two-year Treasury note yields only 0.34 percent, but this is far better than the 0.01 percent provided by the three-month Treasury bill. Secondly, the moves of the Federal Reserve and how the markets will react to them are uncertain. We believe it is not prudent to have zero bond exposure on the day bonds rallied more than any time in the last two years.
CLS portfolios continue to have a lower than normal exposure to interest rates. We are not reducing this exposure to zero. While we are focused on the risks of bonds, we also recognize the extremely low returns for holding merely cash. As long as the market offers meaningful yield improvement for modest interest rate risk, CLS will chart a balanced approach to fixed income allocations for its clients.