A couple of weeks ago Fed Chairman Ben Bernanke hinted that the Fed’s bond buying program known as quantitative easing would begin tapering down in 2013 and, assuming that the economic indicators were still positive, that the program would come to an end in 2014. We all know what happened next: the stock market plunged, precious metals prices were crushed, other commodities, such as oil and gas prices tanked and bond yields soared as the 10-year treasury notes increased by 50 basis points in the space of a week. This all occurred because Bernanke obliquely suggested a possible change in this Fed program.
Let me make one thing clear: The Fed has not changed its quantitative easing policy. Not yet at least. They are still buying $85 billion in bonds a month. The only thing that changed is the perception that this program will begin to taper sometime by the end of this year and stop altogether in 2014. This is a perfect example of how the market over reacts to economic news. If, as in this case, the market perceives bad news it over reacts and markets plunge. And conversely if there is some good economic news, the market over reacts and stock markets around the world soar. Investors in the stock market can lose lots of money if they buy and sell based on these huge emotional swings caused by the market’s response to economic news.
So what’s going to happen going forward? This is what I think we can safely say about the next 12 months:
ﾷ As The Fed attempts to slow down its bond buying expect more of the same from the markets. So the market fluctuations of the past few weeks are just the beginning. I see no let up of these huge mood swings. If I’m correct, then the days of the secular bull market are over. If you stay invested in stocks be prepared for an emotional roller coaster ride.
ﾷ Interest rates will also fluctuate wildly. I’m not prepared yet to say that rising interest rates are just around the corner. Ben Bernanke knows that a significant spike in interest rates will likely tank the U.S. economy so he will try his best to prevent a steep rise in rates. Unfortunately he has little control over how the market reacts to his speeches as evidenced by the response to his announcement two weeks ago.
Those are two safe predictions. Now let me give you a prediction which no one is forecasting: As long as we continue having runaway federal deficits The Fed will not be able to stop their quantitative easing program. Why? The answer is quite simple. The U.S. bond market, like all markets, is based on the law of supply and demand.
The U.S. federal deficit is estimated this fiscal year to be $650 billion. That is the amount of federal spending that exceeds federal revenues. If The Fed is no longer going to buy these bonds, who will?
Prior to the Great Recession our budget deficits were in the $200 billion range. At that amount of bonds there was plenty of demand from investors and/or central banks from all around the world. China and Japan were particularly big buyers of U.S. bonds. But now we have $650 billion in bonds to sell, not $200 billion. That’s a huge increase. Who is out there willing to buy that volume of U.S. debt? The answer is no one. To make matters worse both China and Japan are having economic woes of their own so they likely will not be buying U.S. bonds in the significant amounts that they have done in the past.
Until we get our budget deficits under control quantitative easing will continue. It has to. The alternative is that the U.S. Treasury allows interest rates on bonds to rise in order to increase demand for the amount of bonds that will need to be issued. Any guess what the interest rate would have to be in order to balance supply with demand? I shudder to think.
In the mean time, what type of investment is the safest bet to withstand the vagaries of the market? Stocks? Bonds? Precious metals? Other commodities? No not any of these. I’ll put my money on commercial real estate any day, especially commercial real estate that has a low interest rate, long-term fixed rate mortgage. Those who invest in commercial real estate will have the best chance of weathering the coming economic turbulence that’s going to occur from weaning ourselves off quantitative easing. Those who don’t… good luck.
Sources: Bernanke Spoke – Now What? June 21, 2013, Seeking Alpha, by Chris O’Donnell; The End of an Era, June 21, 2013, Seeking Alpha by James A. Kostohryz.