Thursday, June 20, 2013

Market Sell-off Following Hawkish Fed Statement - Does it Make Sense?

Following the FOMC statement yesterday, in which the Fed stated that it will consider reducing the quantitative easing this year and stopping it altogether next year, the global market dropped significantly and bond yield surged. Let's dig deeper and see if there is any opportunities in light of the sell-off.

The Fed is considering stopping the quantitative easing because the US economy is slowly getting stronger and the downside risks to the economy and labor market are diminishing. The Fed lowered the unemployment forecast for 2013 and 2014, suggesting that the labor market is improving.

The strengthening of the economy is actually good news but the market only focused on the fact that tapering would cause interest rate to go up and we will be back to the "normal" market situation sooner than expected. I think that the market is too bogged down to details - it really doesn't make a huge difference whether the Fed will begin tapering in Q4 this year or Q1 next year, or whether it will start lifting interest rates in late 2014 or early 2015. In addition, quantitative easing was a desperate action took by the Fed in hopes of kick-starting the economy; very few people expected the program to run for so long (from November 2008) when the Fed began to purchase securities.

The improvement in the economy will likely drive inflation up, which is actually beneficial to the equities market in the long run as people are more likely to consume in an inflationary environment.

However, for fixed income and commodities, the implication is more complex.

It is pretty certain that the very impressive run over the past few years for fixed income return will end as rates start going up. The credit spread for fixed income had been squeezing so much when investors looked for yield and continued to purchase riskier bonds as yields continued to go down. I believe this trend will be reversed and in fact this is already happening.

For commodities such as gold and silver where investors purchase it as a store of value, because the commodities generates no return (actually it has negative yield taking into account storage fee etc.), investors will see them to be less attractive when yield increases. Right now, there is virtually no opportunity cost of holding gold because the safe alternative (treasury note) is also generating close to zero return. However, it will not be the case when yield rises. Therefore, I think that commodities will at best stay at the current range in the next few years.

So in conclusion, I believe it is wise to reduce the exposure in bonds and commodities and purchase equities in light of the sell-off.