Sometimes the markets just make no sense. Fortunately, those are also the times when a perceptive investor can make the best returns.
The market plunged 1.2% in March when Fed Chairman Janet Yellen, pressed by Congress for a timetable for raising rates after the end of the purchase program, said that Fed language "probably means something on the order of around six months."
Pair this with remarks by several Fed presidents lately, and you might get the impression that interest rates would start creeping higher in advance of an eventual Fed exit from its easy-money policies.
But the market just doesn't see it that way.
And why should the market see anything but easy money and blue skies ahead? Evidenced in the chart below, the Fed has been extremely accommodative over the past five years, and asset prices have moved nearly in lockstep with the increase in monetary stimulus.
Complacency On Rates
According to a Bloomberg survey last month, most economists expect the Fed won't increase interest rates until mid-2015 at the earliest, and some believe it will start even later.
Several members of the FOMC have sounded warnings lately that the market is complacent on rates. Philadelphia Fed President Charles Plosser said the central bank "should not keep rates at zero until we reach our objectives" and that the Fed is "closer than a lot of people think" to raising rates. Kansas City Fed President Esther George, one of the FOMC's more hawkish members, has pointed to improving labor conditions and said a rate increase could happen as soon as this year.
While a rate increase this year is highly unlikely and the surprise would send the markets into a tailspin, the second-quarter U.S. GDP numbers may give the market its wake-up call.
The core personal consumption index (PCE), the Fed's preferred inflation gauge, climbed 0.2% in May and was up 1.5% on the year. This is still below the Fed's 2% target, but it's up from 1.1% in February. The increase over that three-month period works out to an annualized rate of as much as 2.8% -- well above the Fed's target. An incredibly weak first quarter likely held back spending and prices, but that could mean higher inflation on the rebound over the next several months.
The Fed's other mandate, job growth, reaffirms a strengthening economy and higher rates. Despite multiple attempts to play down strength in the labor market, the current unemployment rate of 6.1% is close to the Fed's initial 6% target. The past six jobs reports have shown the economy adding more than 200,000 jobs a month, with June's report blowing by all estimates with 288,000 jobs.
Experienced Fed watchers know that the group is trying to guide communication on rate increases so stocks do not sell off when a rate increase comes. The fear is that if rates do not slowly move higher, we will see a sudden jump when the central bank starts raising rates. That could cause a jolt in the capital markets even worse than we experienced in May of last year.
So: Is The Bull Run Over?
An increase in rates without economic growth strong enough to support asset prices could eventually bring an end to the bull rally, but that is still probably at least a year away. High cash balances are driving acquisition activity, and easy money policies across the developed world should help support global growth and sentiment for now.
The most evident and pressing challenge will be for interest rate-sensitive investments. The Utilities Select Sector SPDR (NYSE: XLU) underperformed the general market by more than 8% as rates jumped in the past two months of 2013. Other rate-sensitive sectors like consumer staples and real estate investment trusts (REITs) underperformed as well before rebounding in the first half of this year.
While investors could hedge their positions in some of these sectors, there is a more direct way to get ahead of the curve. My favorite hedge for the theme is through put options in the iShares 20+ Year Treasury Fund (NYSE: TLT), which holds government bonds and moves inversely with rates. The fund has climbed 10.6% since the beginning of the year on the drop in Treasury rates.
Put options on the fund allow you to benefit when rates do increase and can help mitigate some of the rate risk you have in other investments. An increase to a yield of 2.85% on the 10-year Treasury by year's end could mean a loss of 5% on the Treasury fund.
Risks to Consider: The Fed has refined its communication strategy over the past several years and may still be able to manage expectations in the market. This could help avoid a sell-off in asset prices, especially if Treasury yields come up gradually instead of a quick burst higher, as seen last year.
Action to Take --> Just as the Fed calmed investors with constant affirmations of monetary policy after the financial crisis, the central bank is now trying to manage expectations for the eventual end of its easy-money policies. With volatility still low, buying options for protection is relatively cheap, and investors may want to use TLT to guard against an increase in rates. Investors should also examine their rate exposure in their bond portfolio and in utility stocks.