This morning investors were greeted by some unwelcome news published in the Wall Street Journal. Fed Gears Up for Stimulus, by Jon Hilsenrath and Jonathan Cheng, suggests the upcoming QEII is likely to result in an initial purchase of Treasuries "worth a few hundred billion dollars over several months." For weeks now the generally accepted guess was that an initial announcement of $500 billion was the absolute minimum. The range of predictions, while is primarily clustered around $1 trillion, reached $2 trillion on some accounts. Much of the discussion also revolved around the potential for further "shock and awe" were the Fed to deviate from expectations. The WSJ report has induced greater uncertainty in the markets as we await the official announcement next week.
As markets digested the news this morning, the dollar continued its recent rally, sparking selling in stocks, commodities and bonds. The durable goods orders, expected to offer positive news, came in above expectations on the headline number. However, excluding transportation, orders actually fell 0.8% in September, coming in well below expectations. As CNBC noted this disappointment, the stock market drifted lower throughout the morning. (Side note: At the market close, CNBC reported that a better than expected durable goods report helped offset weakness from a dollar rally. The multitude of ways each economic report can be broken down does wonders for a media required to explain the markets move each minute of the day.) When the dollar index (DXY) rallied above 78 mid-morning, all other assets sold off dramatically (Dow down 150, Gold down $20, Oil down $2). The VIX surged higher coincidentally by nearly 10%, coming within blows of its 200 day moving average around 22.4 (VIX fell below 18 on 10/13). As the afternoon rolled along, strength in tech rallied the Nasdaq to a positive close, pulling the Dow and S&P back to only minor losses on the day. The strength in stocks continued a recent divergence from dollar strength, which also closed slightly off its intra-day peak. Meanwhile treasuries continued their recent, dramatic sell off as the 10 year yield ended above 2.7% and the 30 year yield moved above 4%.
The recent sell off in treasuries has practically erased all previous gains since the prospect for QEII was made clear by Ben Bernanke in a speech at Jackson Hole back in August. Surprisingly, the sell off has actually come in advance of QEII, for which the primary intention is to drive down long-term interest rates. Most notably today, the "Bond King", Bill Gross declared in his November investment outlook, Run Turkey Run, an end to the 30-year bull market in bonds. After some poignant comments on politics, Gross explains that while in the short-run the Fed can drive bond prices higher, ultimately inflation and real negative interest rates erode any value. Although many others in the investment community will surely disagree with Mr. Gross' conclusion, his theory is certainly worth contemplating.
If the bond market's bull run is officially dead, it will be important to understand the potential ramifications on investment decisions going forward. Given the extreme sum of money that has been shifted to bonds over the past couple years, a consistent rise in rates may force many investors to question their portfolio allocations. Initially funds may be shifted back to equity markets pushing valuations higher. However, just as lower yields imply higher earnings multiples, higher yields will shrink multiples going forward. Many other questions will also be answered in time...
Given being long bonds is a crowded trade, will consistent selling inspire further position reductions and potentially panic selling? If panic selling took hold, would the Fed step in again and potentially extend its duration in purchases? How will rising rates affect an already weak housing market? If the Fed holds short-term rates near 0% while yields on lengthier maturities rise, will the steepening yield curve benefit banks? Or will banks, currently heavily invested in bonds, face significant investment losses due to rising rates?
A related investment idea to close on is Annaly Capital Management, Inc. (NLY). Annaly's basic business is borrowing funds at the short end of the yield curve, purchasing Agency MBS and earning the spread in yield. The firm uses swaps to hedge their interest rate risk and a quick read through commentary on their website reveals impressive knowledge of the real estate markets they trade in. The company reported earnings after hours today and the stock dropped several percent following the report. A noticeable weakness in the report was the reduced spread being earned due to the flattening yield curve in recent months. However, with the Fed expected to hold the short end near 0% indefinitely, and potentially rising yields on the long end of the curve, Annaly will likely see increasing spreads going forward. Also, the stock pays out most of it's earnings in dividends and currently yields around 15%, which may prove special in a low-return environment.
Disclosure: No position in NLY.
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