Bubbles in the economy are formed when there is an economic cycle of rapid expansion and the bubble bursts when there is a sudden contraction in the economy. This usually means that the price of a financial product overshoots its intrinsic value and continues to increase until the bubble bursts. After the financial crash of 2007-2008, a lot of governments, most notably those of the US and UK, started performing helicopter drops in order to drive interest rates in the economy down. This helps households and business to borrow more and at a lower cost and also supports the prices of many assets such as stocks.
Timeline of the Fed’s Quantitative Easing program
After the real estate bubble burst, the Federal Reserve engaged its quantitative easing program (QE1, QE2, and QE3) – buying government and mortgage-backed securities (MBSs) – with the intention to reduce long-term interest rates, provide liquidity to the market, and guarantee the mortgages issued by the government-sponsored enterprises Fannie Mae and Freddie Mac. While in QE1 (2008-2010) the focus was on purchasing mortgage-backed securities, during the second round of quantitative easing (2010-2011), the Fed aimed more at long-term Treasury securities. In August 2010, the central bank started reinvesting principal payments from agency debt and mortgage-backed securities into long-term government debt. The Fed was hoping that by providing so much liquidity to the markets, banks would become more relaxed and start lending more. However, a lot of banks preferred to keep the money they received in their vaults as reserves due to the economic uncertainties and this impeded money creation. In September last year, the Fed started its third round of quantitative easing announcing that it would purchase $40 billion worth of MBSs per month for as long as the markets needs it. The central bank also said that it would be increasing its holdings of long-term securities, i.e. Treasury bonds, by $85 billion each month. This is also known as ‘Operation Twist’ because the Fed started “twisting” its bond holdings – its sells short-term bonds and buys long-term ones or the other way around, depending on which interest rates it wants to reduce. By the time Fed Chairman Ben Bernanke announced QE3, the bank had already purchased over $2 trillion in government securities. By purchasing trillions and billions of Treasury bonds and bills, the Fed has pushed their prices up. Here one can start seeing a similarity with the definition of bubbles, given in the beginning of the article – market prices ignore intrinsic value.
Yields and bond prices have an inverse relationship
Is there a bond bubble?
Ever since the beginning of 2013, bond yields have been mostly on the rise. With the US economy strengthening and adding more jobs each month, investors started fearing that the Fed would wind down its stimulus package. In April, however, the uptrend was broken due to weak unemployment data missing analysts’ forecasts. The economy added 88,000 jobs instead of the expected 200,000 which was below even the lowest estimate in a Reuters poll. Average yields for the benchmark 10-year Treasury bonds for the month were 1.76 percent, 20bp less than in March. At the beginning of May, jobless claims fell to their lowest level since the beginning of the 2007-2009 recession and the market was very fast to react favourably to the good news.
At the same time the economy added 25,000 jobs more than analysts were expecting. Investors saw in these numbers a sign that the economy was improving and that the Fed might stop or at least slow down its bond-purchasing program. In a speech on May 22, Ben Bernanke said that the US Federal Reserve might decide in the following few meetings of the Federal Open Market Committee (FOMC) to slow, or ‘taper’, the $85 billion-a-month program if labour conditions continue to improve. This, however, is not yet the case. As Bernanke spoke in front of the Committee, markets soared as he clearly contradicted all speculation of an early tightening of monetary policy. Later in the day, however, investors started interpreting his words with exactly the opposite meaning and prices slumped below their original opening levels. There can be various reasons behind their interpretations, but the fact is that tens of billions of dollars were redistributed among speculators who had interpreted different meanings in Bernanke’s words. Ever since that moment, however, yields have been rising and they are currently almost at 2.8 percent.
Last month, popular columnist Martin Hutchinson, stated that the 32-year bull market in bonds is ‘officially dead’. He said that he expects rates to gradually rise this year reaching 3.3 percent by December 31. It shouldn’t be a problem for investors to adjust to such a yield which is below the average for the end of 2009 and beginning of 2010. Hutchinson is more concerned about next year when he expects that the gap between short-term and long-term interest rates will increase with the Fed unlikely to raise short-term rates. High long-term interest rates will eventually lower the value of the mortgage portfolios of companies in the mortgage REIT sector and thus reduce their capital which could possibly drive these companies to bankruptcy.
Warren Buffett, himself, said back in May that fixed-income securities are “a terrible investment right now.” He advised investors to have enough cash on hand so that they feel comfortable and put the rest in equities which “grow in value over time because they [stocks] retain earnings and they expand the companies underneath”
QE’s impact on the stock market and how tapering may impact it
The Fed’s QE program hasn’t affected only bonds but the stock market as well. Peter Bennett, a money manager in London, makes the case using basic math and stock valuation concepts. The most widely used method for this is the Gordon Growth model. Using this method we discount all future cash flows (FCF) which we as investors will receive assuming a constant rate of growth. In the case of stocks, these FCF are the dividends which the company pays out and the growth is by how much the company increases these dividends each year.
Using the current market interest rates (the benchmark rate is the one of the 10-Year Treasury bonds) you discount all those future dividends to their current value, i.e. you calculate how much money you could’ve made if you put your money in a bank deposit instead. For the sake of simplicity we’ll assume that dividends don’t grow. At the beginning of May, the average 10-year yield was in the 1.6 percent range while a few days ago it was around 2.7 percent. Let’s assume that the company pays out £5 in dividends each year and you’re going to hold the stock for an indefinitely long period of time. At the 1.6 percent rate, this means that you price one share at £312.5. At this month’s 2.7 percent, the price becomes £185. A 1.1 percent change in interest rates led to a 69 percent change in the stock price of our virtual company. If we add a growth rate, the difference becomes even bigger.
By pushing interest rates down, the Fed has artificially overpriced stocks and now when things start reversing, the stock market will likely be hit as well. Fundamentally, increasing interest rates will make it more difficult for companies to borrow money and if they are not ready to face the “usual” rates, we can see a negative response of the stock market when the Fed starts tapering its stimulus.
To put things in perspective, back in May on the same day Ben Bernanke made his speech in front of the US Congress, the FTSE 100 index slumped 143 points or 2.1 percent and the Nikkei 225 dropped more than 7 percent overnight. “This neatly illustrates the irony of the position; traders across the world are openly hoping for poor US data since this keeps the Fed involved,” said Rupert Osborne, futures dealer at IG. Last week, when US weekly jobless claims fell to a near six-year low of 320,000, the stock markets in the US and Asia tumbled due to increasing expectations that the Fed will wind down its QE program. While most analysts are speaking of a bond bubble, it is quite possible that stocks are being overpriced at the moment as well and will suffer a mighty blow when the stimulus package is reduced.
Gold – safe haven will start losing its appeal with QE tapering
When the Fed starts tapering its stimulus program bond yields will increase even further and this will likely make bonds a better investment than gold in the eyes of the markets. Also the overall improvement in the economy will eventually boost investors’ morale and they will return to investing in riskier assets.
“This time is different”
The Fed’s QE program has been very helpful for the US economy and this is indisputable. However, it is important that we know we note and remember that it has its negatives because “this time is different” is a fallacy. Even Ben Bernanke has said that the Fed acknowledges that there are risks associated with very low interest rates for prolonged periods of time. Portfolio managers dissatisfied with the low returns on the market might engage in riskier investments, for example. Many analysts believe that the tapering might start as early as September this year with the Fed announcing it at its September 16 meeting. Whether it will be September, October or some time later, it will most likely happen in the next couple of months. It is important that the Federal Reserve acts very gently, as the economy can easily overreact to any decisions made by the central bank.