Second Guessing

Second Guessing

Markets recently have had a rocky time as investors in aggregate reassess prospects for monetary policy stimulus in the United States. Is this something to worry about?

The world’s most closely watched central bank unsettled financial markets by flagging it may start scaling back its bond purchases later this year.

Under this program of so-called “quantitative easing”, the US Federal Reserve buys $85 billion of Treasury bonds each month as a way of keeping long-term borrowing costs down for families and businesses and to help promote economic recovery.

What spooked the markets was a comment by US Federal Reserve chairman Ben Bernanke on 22 May that the central bank in its coming meetings may start to scale back those purchases.

The mere prospect of the “monetary tap” being turned down caused a reassessment of risk, leading to a retreat in stockmarkets, a broad-based rise in bond yields (with a subsequent fall in bond prices) and a decline in some commodity markets and related currencies like the Australian dollar.

Gold, in particular, was hit hard by the US Federal Reserve signals, with the spot bullion price falling 23% between 1 April and 30 June on the view that rising bond yields and a strengthening US dollar would hurt its appeal as a perceived safe haven.

For the long-term investor, there are a few ways of looking at these developments.

Markets react quickly

We are seeing a classic example of how quickly markets efficiently price in new information. Prior to Bernanke’s remarks, markets might have been positioned to expect a different message than what he delivered. So they adjusted accordingly.

U.S. economy is recovering

The reason the US Federal Reserve is considering winding back bond purchases is because the US economy is showing signs of recovery. This is a good thing and highlights how policymakers and investors are constantly reassessing every aspect of the global economy.

There are never more sellers than buyers

For all the people quitting positions in risky assets like shares or corporate bonds, there are others who see long-term value in those assets at the lower prices.

The idea that there are more sellers than buyers as often mentioned in the press is just silly. For anyone who sells a security at a particular price, someone else must think there is a good reason or value to buy.

Logic doesn’t equal inevitability

The rise in bond yields is a signal that the market in aggregate thinks interest rates will soon begin to rise in the US. That is what the market has already priced in. What happens next we don’t know.

Keep in mind that when the US Federal Reserve began its second round of quantitative easing in late 2010, there were dire warnings in an open letter to the central bank from a group of 23 economists about “currency debasement and inflation”.1

Yet, US inflation is now broadly where it was then and the US dollar higher than when those warnings were issued, suggesting basing an investment strategy around supposedly “expert forecasts” is not always a good idea.

So it would pay to exercise scepticism with respect to predictions on the likely path of bond yields, interest rates and currencies in the wake of the Fed’s latest signalling. Just because something sounds logical doesn’t mean it’s going to happen.

Lower prices means higher expected returns

A rise in bond yields equates to a fall in bond prices. Just as in equities, a fall in prices equates to a higher expected return. So selling bonds after prices have fallen echoes the regrettable habit of some share market investors who buy high and sell low.

Read the sport pages instead

Finally, keep in mind the volatility is usually most unnerving to those who pay the most attention to the daily noise. Those who take a longer-term, distanced perspective can see these events as just part of the process of markets doing their work and reasonably efficiently pricing in all factors.

After all, the individual investor is unlikely to have any particular insights on the course of global monetary policy or bond yields or emerging markets that have not already been considered by the market in aggregate and reflected in prices.

What individuals can do, with the assistance of a professional adviser, is to manage their emotions and to remain focused on their long-term agreed goals.

Otherwise, the risk is you react to something that others have already countenanced, priced into expectations and moved on from as further information emerges.

Inevitably, second guessing markets means second guessing yourself and creating ongoing and unnecessary anxiety into whether you’ve made the right timing decision or not.

In conclusion, your own investment strategy should reflect your own risk/return preferences and should not be changed on the basis of fear, forecasts or trying to guess the direction of markets. Your portfolio is required to provide you with income over a long period of time, so long term trends are far more important than short term noise.

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1. ‘Predictions on Fed Strategy that Did Not Come to Pass’, Floyd Norris, New York Times, June 28, 2013

Author: Rick Walker

 

Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.