The 3rd quarter market chatter primarily revolved around the anticipation of the Federal Reserve’s resolve to finally begin to reduce its bond buying, which commenced a year ago as part of QE3. The conventional wisdom was that there was going to be a slight pull back of the targeted bond buying or “Taper” meaning a reduction by 10% or so of the monthly $85 billion bond buying program. The Fed ultimately surprised the markets at the conclusion of the two day meeting on Sept 18th with no tapering announcement at this time. In its statement, the FED said that, “tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.” So the Fed decided to wait for “more evidence that progress will be sustained before adjusting the pace of its purchases”. Was this meant to be code for, “Mortgage rates jumped too much and we are worried about stopping an already slow recovery”?
Markets at first rejoiced and then promptly sold the following day, now turning its attention to Washington gridlock related to the debt ceiling and now government shut down. The DJIA closed down 7 of the final 8 trading days to end the quarter.
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In 1981, the yield on a 10 year U.S. Treasury peaked at over 15%. Over the last 30 years, fixed income investors have largely experienced a “bull market” for bonds as yields have consistently fallen, bottoming out in July 2012 at 1.53%. With the Federal Reserve taking unprecedented monetary policy action through the setting of the federal funds target rate between 0% and 0.25%, coupled with their bond purchases of $85 billion monthly, rates don’t have much room to fall further. As the Fed “tapers” their bond buying, and eventually raises the fed funds rate, what effect will investors see on their portfolios? It is widely known that as bond yields rise, bond prices will fall. An investor who purchases a hypothetical bond today yielding 2% will earn $20 of interest annually per $1,000 par value bond. If yields were to rise to 3%, an investor can now earn $30 of interest per $1,000 par value, therefore making the 2% bond less valuable, resulting in a reduction in price. Investors today face heightened interest rate risk, the risk that rising yields will make their fixed interest rate bonds less valuable, as it is inevitable rates will rise in the future.