When the Music Stops

John Osbon - March 22, 2011

Markets hum along to their own beat and rhythm, until they don’t. From time to time, the music suddenly stops.  It might be Libya, devastation in Japan, or potential bankruptcy in Greece that triggers a sudden silence and jarring price dislocations. We typically get no advance warning at all. This time, however, we know when a big one is coming – the day the Fed stops buying all those Treasury bonds our government is issuing. What happens then?

The Fed, in its commitment to greater communication and transparency, has indicated it will likely end “QE II” (the second round of what it is calling quantitative easing) on June 30, 2011.



QE2 sails into the distance

Here’s QE in a nutshell: When you need a lot of money and can’t come up with it any other way, you borrow. If your finances don’t improve and you need to borrow more and more, you will likely have to promise a higher and higher interest rate to your lenders. To avoid this you may convince a wealthy uncle to take on your debt at an artificially low interest rate. If the uncle eventually says “No mas,” you’ll need to find a new plan, most likely involving higher interest payments.

This is what the US has been doing with QE. The Fed (the wealthy – or at least willing – uncle) has bought up billions of treasury bonds (70% of those recently issued), keeping rates low. But the “No mas” for QE is apparently on the way. Without getting into all the philosophy on QE and whether or not it has achieved its goals, let’s ask the forward-looking question: When the obliging uncle exits the scene, what will happen in the bond market?

Bill Gross moves on

Maybe there’s another wealthy uncle on the other side of the family? Some would look to bond king Bill Gross of Pimco as the likely candidate. But he’s already made it pretty clear that his appetite for treasury bonds has waned. (See what Gross has to say on the subject, and a differing view from Cullen Roche of Pragmatic Capitalism.)

So the music’s going to stop, or at least noticeably change its beat. With continuing deficits, the government will still be looking for buyers of debt. But if the Fed stops buying and rates rise as a result, that means bond prices will fall. (When bonds paying 5% become available, existing bonds of similar risk that pay only 3.5% are less desirable and fall in value.)

But we can’t know for sure. As all markets remind us week in and week out, we don’t know what will happen or how long it will last until it happens. It’s as true for bonds as stocks. The confluence of factors affecting rates is just too complex. Predicting rates is like predicting the weather – interesting, yes, but reliable?  Ultimately we are left with informed guesses. We know it’s likely to be warm and sunny in Boston on June 30th, but it could be raining, cloudy, or blowing a gale. The temperature will likely be somewhere between the all time records for that day (a low of 30 and high of 104). That’s not much guidance.

Do the math

So how can investors prepare for the impending silence in the music? Diversification, planning, and a little arithmetic.

Too much of any single asset class opens a portfolio to unpleasant, concentrated shocks when conditions change. Diversifying across many asset classes typically softens the impact related to any single economic, political or market change.

And while interest rate changes cannot be predicted, one can easily discern the impact on bond values in response to hypothetical future rates. Interest rate and price always move in opposite directions; the math is formulaic. For instance, if yields on benchmark 10 year treasury bonds rose by 2 percent, the value of existing 10 year bonds would fall by 15%.

Tuning the portfolio

With this in mind, any portfolio can and should undergo regular stress tests for changing interest rate, stock market, currency and commodity scenarios. Testing what-if possibilities related to interest rates can help to determine asset allocations that are consistent with your goals and risk tolerance. It’s also helpful to look at long term performance of bonds to understand how current conditions resemble or depart from historical trends. We can also look at historical correlations between asset classes for some guidance.

None of these analytics can answer all our questions about the bond market, but taken together they may help to tune your portfolio in anticipation of the musical change on the horizon.

 

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