One of the most dangerous situations is when an investor attains a false sense of confidence. With the Federal Reserve enacting such an aggressive monetary policy stance, this has led to reduced levels of volatility and an uncanny calm in the financial markets.
Because the Federal Reserve has stepped into the financial markets with such a large level of support through their monetary policy program, this has led to bond prices that remain elevated and yields that are at very low levels. Not much has occurred over the past few years in terms of shocks to the system.
The danger occurs when investors believe this situation will remain in place forever. Nothing lasts forever and one should always prepare for the future.
So far, the net result from the monetary policy action by the Federal Reserve has been higher home prices, an increase in car sales, higher asset prices in general, such as stocks, and a general calm in the financial system.
What happens when the Federal Reserve starts to reduce its monetary policy stance? I think it will hit many sectors, but it will especially affect the bond market.
The President of the Federal Reserve Bank of New York, William Dudley, recently stated that the accommodative monetary policy stance needs to remain for the time being, due to continued weakness in employment growth. However, he did add that the Federal Reserve should begin adjusting monetary policy as the economy improves. (Source: Zumbrun, J., “Dudley Sees ‘Very Accommodative’ Policy on Weak Job Market,” Bloomberg, March 25, 2013.)
The U.S. economy still has not employed all those who lost their jobs since the recession. Approximately 5.7 million jobs have been created, although 8.8 million people have lost their jobs since the recession.
While the latest weekly claims for unemployment continue to improve (currently at the lowest level since February 2008) and the economy is creating approximately 200,000 jobs per month on average, it is still not at optimal levels.
A large amount of blame has to go straight to Washington. I believe that with the accommodative monetary policy that the Federal Reserve is implementing, if there was true leadership and a pro-business environment in Washington, the U.S. would be growing its economy at a much faster rate. However, Washington’s ineptitude continues to weigh down on the U.S. economy.
My worry is that investors don’t see the potential for bonds to lose value and interest rates to rise anytime soon. If Washington can get its act together, we could be looking at a scenario in which the Federal Reserve begins discussing the removal of some of the accommodative monetary policy fairly soon, perhaps in the fall or early 2014. Once that happens, investors in bonds will be holding large losses.
While the Federal Reserve is slow in adjusting its monetary policy, the market is not. The bond market, especially, will run for the exits on any hint of a monetary policy adjustment. The miniscule yields now being offered will be completely wiped out.
The old saying is that the trend is your friend. If we look at the employment situation, while it is still quite anemic, is it worse or better than the last couple of years? Obviously, it is better. The trend is for continued improvement, and until we see a shift in which unemployment begins rising, I would look for bonds to decrease in price and interest rates to start rising later this year and into next.
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