. As the market is being
heavily shaken, many are searching for their footing while trying to figure
out what's going on. The common catalysts for shaky markets in the past few
years are nowhere in sight. There's no tragedy taking place in Greece,
Portugal, Italy, Spain, or Cyprus – the countries that have dominated the
headlines since the crash. There's no confusion in Congress keeping the
markets on edge.
Instead, the reason is
one straight from the textbooks: interest rates are moving higher, and the
stock market is getting hit.
In the face of higher
interest rates, Wall Street wanted to hear something along these lines from
the Fed: "The recent rise in rates is counter to Fed policy, and if
necessary, further actions will be taken to keep them low." But that's
not what Bernanke gave the market. While the Fed didn't promise to raise
rates soon, Bernanke seemed unconcerned with the recent rate climb on the
10-year Treasury. This aloof attitude signaled that higher rates are here to
stay.
Rather than reassuring
the market on Wednesday, Bernanke's comments pushed rates even higher with
his disregard for the situation. In a matter of two months, the 10-year
Treasury has climbed 76 basis points (0.76%), from 1.65% to 2.41%. In his
press conference, Bernanke attributed the increase to three factors: stronger
markets; anticipation of Fed policy; and additional unknown factors. The key
takeaway here is that the Fed believes that the prime catalyst for the rate
increase is factors other than policy anticipation. If the rise was the
result of policy anticipation alone, the Fed could send rates down by simply
saying so. Since that's not the case, corrective action from the Fed is much
less likely.
Furthermore, Bernanke
dashed the hopes of more accommodative policy in other remarks during his
press conference. He said that the low level of inflation is only
"transitory" and should move back up to the 2% area by itself –
meaning the Fed will not take any action to push it toward the 2% mark, as was
previously suggested in recent FOMC minutes.
On top of this, Bernanke
described the Fed's strategy for the eventual reduction of its easing policy.
The details aren't what shook the market – there was nothing huge and no
change in direction. This lack of change is exactly what scared the market.
The Treasury market is in a different place than it was several months ago.
We're now in an environment of rising rates, yet the Fed's policy remains the
same.
In a sense, by the Fed
taking no action in light of higher rates, the Fed has taken a major step in
signaling the end of low rates. The Fed is telling the market that it accepts
slightly higher rates, and it won't do anything about them. What we're
experiencing now is not the result of some unforeseen events. We are just
stepping back in to the real world – a place where interest rates are zero
forever. That doesn't mean the market is all downhill from here, but the era
of easy gains is winding down.
Is It All Bad?
When there's red numbers
across my brokerage account – it's hard to say this – I'm pretty happy with
what's happening in the market. Rates were inevitably going to rise; it's
just happening sooner than most people expected. Whether they rise tomorrow,
six months from now, or three years from now, the process was going to hurt.
In fact, the longer one puts off higher rates, the more painful the eventual
move up. Personally, I'd rather take a little pain now than have my portfolio
beaten beyond recognition later.
Hoping the Fed will
promise yet more stimulus is only delaying the
inevitable, and that doesn't get us anywhere. Even though the Fed would like
to keep rates low forever, it can't do so – this had to happen.
Another reason to see a
silver lining is that things are tough in the market, but they could be a lot
worse. Many investors envisioned absolute terror at the first sight of higher
rates. Yes, it's pretty scary right now, but in comparison to Lehman in 2008,
this is a cake walk. The DJIA is below 15,000, but I'd be surprised to see a
dip below 14,000 soon. If the ten-year Treasury could move this smoothly to
around 5% – as will eventually happen – we should consider ourselves
fortunate.
Lastly, we should be
thankful for the clear wakeup call – particularly for yield-seekers. The
spike in rates has deflated small speculative bubbles in a number of yield
instruments. Long- and intermediate-maturity bond holders were rudely
awakened, but other sources of yields took major hits as well, such as REITs
and utilities, which have been down over 10% in the last two months.
To some that sounds
horrible, but higher rates are doing those investors a favor – this is
officially fair warning of things to come. Personally, I'd rather take a 10%
loss on a utility stock now than take an even bigger loss when the Fed pulls
rates higher. The same goes for bonds. If you haven't already gravitated to
shorter-term maturity bonds, it's time to seriously consider it. The party
isn't quite over yet for long-maturity bonds, but the bartender is making the
last call. It's time to get out of the bar before you get kicked out.
So why are the Fed and
Bernanke so quiet on this recent rise in rates? In many ways, it serves them
well. On the one hand, the Fed wants lower rates to stimulate the economy. On
the other hand, if the Fed does plan to move rates up in mid-2015 as it
promises, then this is a good first step. All things considered, rates have
moved upward with minimum pain. The Fed only needs to move them a bit more in
mid-2015 – hopefully again with minimal pain.
If the Fed pushes rates
back down, it will just have to pull them back up again in the near future,
should things go according to plan. Sure, for the time being the economy
would get a little more stimulus, but only at the price of more pain in the
near future. If the Fed pushes rates down by 0.76%, it eventually has to pull
them up again by the same amount. It's a choice between two options: a little
pain now from higher rates and a little more pain in mid-2015; or a lot
of pain in mid-2015, as rates would rise in a single big push rather than
incrementally.
In short, the Fed is
having its cake and eating it too. It can keep its policies exactly the same,
while letting the market drive rates up slightly to drive some of the
speculation out of the market. In many ways, this has been extremely good
fortune for the Fed's long-term goal of exiting QE.
In the long run, higher
rates are good for us – we can't stay in a zero-interest world forever.
However, the market has become so conditioned to the permanent stimulus that
even these slight rate increases are sending shock waves across Wall Street.
What many people forget is that this is what needs to happen, what is going
to happen, and what cannot be stopped. Personally, I'd rather start feeling a
little bit of the pain now rather than jumping off a cliff in 2015.
Instead of seeing May and
June as rough months and crossing my fingers for yet more stimulus,
this is some of the first signs of normality in the stock market for a long
time. Sure, normal doesn't feel so good in our brokerage account, but it's a
little red now or a lot of red later. Take your pick. The former sounds
better to me.
Preparing for the Worst
Recapping the week's
events is one thing – taking steps to protect your portfolio is another. Make sure to keep up with our latest big-picture
views in The Casey
Report.
Also, in Miller's Money Forever, we already took steps to
protect ourselves from rising rates. In recent issues, we placed a stop loss
on our only intermediate bond fund, held on to our short-maturity funds, and
sold our only REIT for a 20% gain – literally a day prior to the REIT market
beginning its slide. Furthermore, our picks over the next few months will be
focused on sources of yield in an environment where rising rates hurt common
yield solutions, such as bonds or utilities. For example, our latest pick is
a diversified fund with a 3.7% yield and very little sensitivity to interest
rates.
Rates have started to
rise. We have all received fair warning. Today is not the time to cross your
fingers and hope that everything will be in the green and up on Monday. Right
now you need to take action to rearrange your portfolio to this new reality. Check out a free trial of Miller's
Money Forever today.
