Stocks, Bonds, and the Fed’s Taper Talk

Categories: History & Geopolitics
Speculation and Investment: Communicating the Differences in Style

Consensus wisdom seems to be that rising interest rates are bad for stock prices.

The Wall Street’s Journal’s July 8 Abreast of the Market column began with a warning for investors:

After Friday’s stronger-than-expected U.S. jobs report, investors are more convinced than ever that the Federal Reserve’s bond-buying program will be scaled back as soon as September. If that happens, the stock market will lose fuel that helped power the Dow Jones Industrial Average to a new high in May.

The concern that interest rates will move higher seems well grounded. On June 19, Federal Reserve Chairman Ben Bernanke laid out a possible roadmap for “tapering” or reducing and then ending the Fed’s bond-buying program. The Fed has been buying Treasury bonds and mortgage-backed securities at a pace of $85 billion a month since the start of 2013, aiming to keep bond yields low to stimulate consumer spending and business investments. If the Fed stops their purchases, it seems reasonable to expect lower bond prices and higher interest rates. When bond prices fall, interest rates rise.

After declining for three decades, interest rates may have hit bottom on May 1 when the yield on 10 year Treasury bonds fell to 1.66%. By July 5, the rate had jumped by more than 1% to 2.73%. Mortgage rates have also climbed.

Some professional bond investors, like Hoisington Investments, are making the case that rates will decline from current levels. Their arguments generally focus on a continued weak economy and the Fed’s failure to accomplish their goal of increasing inflation to 2%. However, betting against the Fed and the economy has been expensive over the past several years.

Lessons of History

Older investors may recall the 1970s stagflation, when stock prices fell as inflation and interest rates rose. But that experience does not mean that stock prices will necessarily decline if interest rates begin to rise from very low levels. Investors should bear in mind that market history shows that rising stock prices and rising interest rates can be compatible when interest rates rise from such depressed levels.

In his recent book, Trading with Intermarket Analysis, analyst John Murphy described the 1946 – 1959 bull market when stock prices rose for 17 years while interest rates more than doubled. As Murphy explains, there were similarities in the Fed’s strategies between then and now:

The Fed’s current policy of keeping bond yields from rising is also preventing bond prices from falling. The last time the Fed tried that strategy was during the 1940s. The Fed started buying Treasuries in 1942 to prevent wartime inflation from pushing yields higher and to pay wartime debt with cheaper money.

It wasn’t until 1951 that the Fed finally let bond yields take their normal course higher. Although stocks rose during most of the 1940s, it wasn’t until bond yields shot up during the 1950s that stocks really took off and continued to do so for the following two decades. It wasn’t until the Fed allowed bond yields to rise, and bond prices to fall, during the 1950s that investors sold bonds and bought stocks in a big way.

Despite rising interest rates, stock prices rose until 1969, interspersed with cyclical bear markets along the way. By that time, 10 year Treasury bond interest rates had climbed to over 7% – quite a long way from today’s low yields.

Reasons for Optimism

I don’t expect a repeat performance of the 1950s and 60s by the stock market today. But investors might be well advised to consider the possibility that the current bull market may have considerably farther to run. There is a growing list of positive trends that could keep the stock market buoyant:

  • Residential real estate prices appear to have stabilized and may have bottomed. Sales of new homes rose 11% between June 2012 and June 2013. This figure is one of the highest year-over-year increases on record.
  • The S&P 500 stock index climbed to new high levels in April, breaking out of a 13 year consolidation. Small and mid-cap stocks have performed even better. As John Murphy has also said: “You cannot predict the stock market by looking at the economy; it’s the other way around.”
  • The Fed’s optimism regarding prospective economic growth and Chairman Bernanke’s willingness to reduce the level of money-printing is a positive long-term economic development.
  • Employers have now added an average of more than 200,000 jobs a month this year. The jobless rate has held steady at 7.6%, but recent job gains compare favorably to average monthly gains of 150,000 during the credit-fueled boom of 2003-2007.

Some pundits argue that the longer term economic outlook is clouded by high debt levels and poor demographic trends. However, this argument ignores substantial technological developments could have material long term positive implications for productivity and the economy.

An April 2012 article in The Economist magazine titled The Third Industrial Revolution suggests that new digital technologies are finally bearing fruit in ways that promise to reshape economies as radically as Britain’s mechanization of the Textile industry in the late 18th century and development of the assembly line in the early 20th century.

Bestselling author and Wired magazine editor Chris Anderson published Makers: The New Industrial Revolution last October, which elaborates on these trends. The potential for new technologies to allow for customized consumer products is not a new idea. More surprisingly, Anderson describes how digital technologies are enabling small entrepreneurs to create new and innovative products that can compete with many mass-made products on price. For example, laser cutters can produce product parts with precision if the right software is coded in to the machine. 3D printing, which is becoming increasingly cheaper, better and faster, allows products to be built out of fused plastic remotely.

Another example of an unexpected benefit from the information revolution is a recent development called “crowdfunding, ” which is a method for gathering money from the public. Crowdfunding circumvents traditional avenues of investment. It is the collective effort of individuals who network and pool their money, usually via the Internet, to support efforts initiated by other people or organizations. The best known crowdfunding platform is Kickstarter. Since Kickstarter was launched in 2009, more than 4.5 million people have pledged over $716 million, funding more than 45,000 creative projects. Sites like Kickstarter don’t allow investors to reap financial rewards for contributing to projects. Such activities would be considered selling unregistered securities. However, investors can often receive a product or service in lieu of a cash return.

Investors bounded by historical paradigms might be missing a sound reason for stock prices to continue higher. Recent innovations have the potential to reap substantial long term benefits for the economy by making it easier for inventors to create new products than ever before.

Interest rates may rise from current levels. If interest rates increase far enough, the bull market in bonds would be over by definition. However, the same is not necessarily true for stocks when interest rates begin to rise from such low levels.

There will always be well-reasoned arguments for stock prices to fall. But by many measures, stock prices are still reasonably priced, the economy has healed significantly from the 2008 collapse and the stock market is still in an upward trend.

Investors may want to keep in mind that a diversified portfolio of common stocks has been one of the best long term ways to participate in economic growth and build and protect wealth – even through periods of rising interest rates.

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

One comment on “Stocks, Bonds, and the Fed’s Taper Talk

  1. Pingback: Stocks, Bonds, and the Fed's Taper Talk | Inside Investing | ikupelomys

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