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Tapering Fears Allayed? The Bond Market Says ‘Not So Fast!’

Treasuries, MBS aren't reflecting the current storyline


It appears the Fed’s quantitative easing policy will in fact go to infinity.

At least, that seems to be the message of the markets after yesterday’s Fed statement offered no hint that a potential “tapering” of QE is in the cards right away. Stocks reacted favorably to the news, jumping immediately after the statement was released and building on those gains Thursday. So this must mean investors have nothing more to fear from the Federal Reserve, right?

Not exactly.

Although stocks and other higher-risk asset classes have rebounded strongly from the initial shock that accompanied the first mention of  “tapering,” the two market segments that matter the most — Treasuries and mortgage-backed securities — have continued to weaken. These two asset classes, of course, are the target of the Fed’s $85 billion per month of asset purchases, with $45 billion devoted to Treasuries and $40 billion targeting MBS.

In July, the broader U.S. bond market returned 0.38% — as measured by Vanguard Total Bond Market ETF (BND) — amid a recovery in higher-risk, higher-yielding asset classes. At the same time, however, the iShares 20+ Year Treasury Bond ETF (TLT) fell 2.26%, while the iShares 7-10 Year Treasury Bond ETF (IEF) slipped 0.35%. The iShares MBS ETF (MBB), for its part, slipped 0.11%.

The one-month numbers aren’t catastrophic by any means, but these market segments stand out in that — other than municipal bonds, which were pressured by the news of Detroit’s bankruptcy — they were the only two income-oriented segments, in either the equity or fixed-income markets, to finish the month in negative territory.

Which market do you trust?

Which market do you trust?

There’s an important message in the underperformance of these two groups: The smart money — large institutional bond investors — aren’t waiting for an official word on tapering to protect their portfolios. Instead, they continued to seek cover even after the initial disruptions of the second quarter subsided.

This phenomenon can also be seen in the outperformance of short-term bonds relative to their longer-term counterparts in July: while Vanguard Short-Term Bond ETF (BSV) gained 0.43%, Vanguard Long-Term Bond ETF (BLV) fell 0.64%.

Bond investors clearly are shortening duration in an effort to get out of the Fed’s crosshairs.

Bubbles or Balloons: Pick Your Poison

The takeaway is that even though tapering has been removed as a threat in the immediate future, the bond pros are looking further down the road.

And they might not have to wait long for questions about QE’s future to make their way back into the headlines. The Federal Open Market Committee meets again Sept. 17-18, then two more times before year-end: Oct. 30-31 and Dec. 17-18. This means the Fed will have three more opportunities to adjust its language and begin preparing the markets for tapering in a more official manner than it did in May via Ben Bernanke’s initial comments on the matter.

Naturally, the Fed isn’t going to wait until future post-meeting statements to announce its intentions. As is usually the case, it will begin by floating trial balloons through the media several weeks ahead of time to prepare the markets for the shift.

This indicates that even though the Fed is giving the markets the all-clear for the time being, it might not be long before it begins to signal a course change — unless, of course, the economy falls off a cliff.

Preparing for the Inevitable

It’s often said that the market doesn’t discount the same news twice, and the concern about tapering already delivered an uppercut to asset prices in the second quarter before largely dropping off the radar screen. But as long as the bond market continues to reflect uncertainty about monetary policy, it isn’t safe to assume that stocks and other, higher-risk asset classes are out of the woods.

With the CBOE Volatility Index (VIX) under 13, this might prove to be an outstanding opportunity to buy protection on the cheap.

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

Article printed from InvestorPlace Media,

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