Fed’s Taper Will Signal Death Knell for Bond Bull Market

Fed’s Taper Will Signal Death Knell for Bond Bull Market

Brendan McDermid / Reuters

The world is back in taper-watch mode.

There’s a lot at stake – and not just here in the United States – as the Federal Open Market Committee kicks of its two-day meeting today. Not only is it the last Fed meeting of the year – and the last at which Fed Chairman Ben Bernanke will preside before turning over the reins to his appointed (if not yet confirmed) successor, Janet Yellen – but it’s the first time since the September meeting when the question of “The Great Taper” will be firmly back on the table.

The taper, of course, is the moniker now applied to the Fed’s gradual retreat from its longstanding support of the bond markets (and thus, the economy) via $85 billion in monthly purchases of Treasuries and mortgage-backed securities. Clearly, some members of the Fed have been itching to scale back that support for some time, even as the central bank’s balance sheet has exploded in size.

Related: Will Transparency Be Bernanke’s Enduring Legacy?

Until the last few weeks, though, economists have largely agreed that the economic signals that would prompt policymakers to forge ahead with their taper plans have been AWOL. Only now has the unemployment rate dipped to a tolerable level, for instance. The ability of Congress to strike a budget deal also has tilted the balance in favor of economic growth – or at least, away from the unappealing alternative of stagnation.

All of that makes it easier for Fed policymakers to pull back their support for bond markets without fearing that a subsequent increase in longer-term interest rates will derail the economy. That, of course, doesn’t mean that they will act. Indeed, while a nervous stock market sold off for much of last week amidst fears of a taper, the odds that we’ll see action at this meeting are only about one in three, says John Canally, market strategist at LPL Financial.

“But it might not be as simple as a taper/no-taper announcement,” Canally cautions. “We might get a statement to soften us up for a taper at the January meeting, or some other signal, such as an announcement that they’ll have a press conference after the January meeting.”

The latter, he said, would be widely interpreted by the market as a signal that a taper was probable. If the Fed does act, Canally expects an announcement to be accompanied by some kind of reassuring wording about keeping short-term rates low. “It’ll be jawboning, with a bit of bite to it,” he predicts. “A whole bunch of outcomes are possible.”

As the market debates what will happen in the coming days and weeks, investors might want to start thinking about their longer-term strategy. True, a taper isn’t quite the same as the Fed tightening monetary policy, but it’s the first step in the direction of not only a steeper yield curve but higher interest rates overall. And that’s going to be a game-changer for today’s investors, most of whom have come of age since 1980, when the Great Bond Bull Market began.

The end of the 30-year bull market in bonds is hardly news: Bond guru Bill Gross predicted it as far back as last May, while logic has declared that when the yield on the 10-year Treasury bond hit the astonishing levels of 1.6 percent and kept edging lower, there simply wasn’t much more room for investors to profit from a decline in yield that meant higher prices for bonds.

Until this year, similar warnings and predictions had fallen on deaf ears, but the big losses incurred this summer by bond investors as interest rates started climbing are a reminder of the kind of financial pain that will accompany the new trend.

The trend toward rising rates doesn’t mean that we’re in for a complete rout in bond markets. After all, many of the points made by resolute bond bulls throughout the year remain valid today. It’s hard to describe economic growth this year as having been healthy; inflation, at least overall, is almost non-existent. (Even health care costs, long an inflationary bugbear, are rising at their slowest pace in half a century.)

As the end of the year approaches and the taper inevitably draws closer, there’s one message that is important to ponder, however: the days of the traditional, tried-and-true approach to asset allocation, in which investors split their portfolio on a roughly 60/40 basis, with 40 percent going to bonds, are at an end. Or at least, they should be.

There are already plenty of reasons why this asset allocation rule of thumb has become passé in today's markets. For starters, it fails to reflect the diversity of asset classes available to today’s investors (it was formulated back in the 1950s, as modern portfolio theory was gaining adherents); nor does it reflect the real needs of individual investors (one size doesn’t always fit all). It certainly isn’t appropriate in all market environments, as a growing array of pundits have begun to discuss.

One of the earliest and the smartest of these is Chris Brightman, head of investment management at Research Affiliates LLC, who nearly two years ago published a very thoughtful and readable paper pointing out the risks of clinging to the 60/40 model after its expiry date. True, in the first two decades of its life, the model produced average annual returns of 14 percent or so. But looking forward, he predicted the current decade’s returns would be 4.4 percent – barely enough to eke out a positive return after inflation and certainly not enough for investors to claim they are building wealth.

LPL Financial’s Canally predicts that investors will finally give up the ghost early in 2014, once they realize that there is a 20 percentage point gap between the five-year return on their stock portfolios (25 percent) and those on their bond holdings (5 percent).

“At best, they might hope to break even on bonds this year but if they want to keep a significant allocation to fixed income, they’ll have to somehow believe there’s a reason for yields to fall below 1.5 percent and keep sliding,” Canally says. While irrational investors aren’t unknown (gold bugs spring to mind), for the most part, “it’s time to figure out how to get bond-like returns out of something else.”

That’s a theme I’ll return to explore between now and the end of the year.

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