Fed Lights the Fuse on the Bond Market

by Daniel Putnam | December 12, 2012 5:06 pm

The U.S. Federal Reserve switched gears yet again Wednesday, announcing that it will continue to provide stimulus as long as the unemployment rate stays above 6.5%.

This move was widely viewed as being a watershed, since it was the first time the Fed has publicly set a specific unemployment target. However, investors might one day look back at the announcement as a watershed of a different kind — the day that good news on the economy stopped being good news for the markets.

The reason: Instead of having a specific date on which rates will begin to rise — which the Fed had previously targeted as being 2015 — the policy shift now becomes more dependent on incoming data. As a result, the monthly jobs report now takes on much greater importance for the market.

For a look at what might lie ahead, it pays to look back.

In the crisis and post-crisis era, the bond market has been able to withstand good news on the economy because the Fed has long targeted a specific date at which it planned to begin raising rates. As a result, iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT[1]) has been able to post a two-year return of 42.9%, even as the economy has staged a modest recovery. The rally in Treasuries, in turn, has benefited funds such as Vanguard Long-Term Corporate Bond ETF (NYSEARCA:VCLT[2]), ahead 33.1% in the past two years, and Market Vectors AMT-Free Long Municipal Index ETF (NYSEARCA:MLN[3]), up 30.2%.

But it wasn’t always this way: Recall that in the pre-crisis years, and especially during the 1990s, the bond market would take a much larger hit from positive data or higher-than-expected inflation readings than it does today.

We now might be headed back to that world.

Consider the following scenario: Next month, the unemployment rate ticks down to 7.5% (the same 0.2% drop it registered last week). Suddenly, the jobless rate will have fallen 0.4 percentage points in just two months — and it would stand only 1 percentage point above the Fed’s target. The likely outcome is that investors would begin to discount a rate hike sooner than the previous 2015 target. With the 10-year Treasury note changing hands at 1.7%, this is just the sort of news that could lead to a sudden downturn in bond prices.

Will this happen? Not necessarily. The economy could remain sluggish and the Fed could prove correct in its prediction that unemployment won’t hit 6.5% for another three years. And in the near-term, the jobless rate could just as well tick up as it could decline.

But that’s not the issue at hand. Instead, the takeaway here is that the change to Fed policy means the bond market is much less likely to take a sanguine view of better economic news than it was before. This means more volatility, greater data sensitivity and — in a worst-case scenario — an earlier-than-expected onset of the long-anticipated bear market in bonds.

In short, if the bond market is indeed a time bomb waiting to go off, the Federal Reserve has now lit the fuse. The question now is just how long this fuse will be.


Remember this?: 10-year Treasury Note, 1993-1996

What Does this Mean for Stocks?

At first glance, it would appear the shift in policy direction would be a negative for equities. In recent years, good news for the economy has almost always been good news for the stock market. Witness last Friday, when the better-than-expected employment report sent the Dow Jones Industrial Average up 81 points on the day.

However, the Fed’s policy shift raises the odds that the markets will take a less favorable view of such developments in 2013.

Could this mean that a better-than-expected economic recovery would bring about a bear market? In reality, that’s highly unlikely. First, stocks have shown the ability to rise even through periods of rising rates — as was the case in 2003-05. Second, the onset of a bear market in bonds would likely lead to a reallocation trade that would benefit equities — a shift that Bank of America dubbed the “great rotation”[5] earlier in the month.

For the stock market, the primary result of the Fed’s shift is therefore unlikely to be a protracted decline, but rather greater day-to-day volatility associated with economic data.

Traders, man your battle stations.

The Bottom Line

Previously, bond investors could remain confident that Fed policy would prop up the market at least for another two years. Now, the Fed’s increased transparency has, ironically, caused that outlook to become much less clear than it was before.

Fixed-income investors, beware: The bull market might end sooner than you think.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

  1. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT
  2. VCLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=VCLT
  3. MLN: http://studio-5.financialcontent.com/investplace/quote?Symbol=MLN
  4. [Image]: https://investorplace.com/wp-content/uploads/2012/12/tnx.jpg
  5. “great rotation”: http://blogs.barrons.com/incomeinvesting/search/great%20rotation/?s=great+rotation

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