Welcome to the Real World

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Published : June 25th, 2013
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Category : Editorials

. As the market is being heavily shaken, many are searching for their footing while trying to figure out what's going on. The common catalysts for shaky markets in the past few years are nowhere in sight. There's no tragedy taking place in Greece, Portugal, Italy, Spain, or Cyprus – the countries that have dominated the headlines since the crash. There's no confusion in Congress keeping the markets on edge.

Instead, the reason is one straight from the textbooks: interest rates are moving higher, and the stock market is getting hit.

In the face of higher interest rates, Wall Street wanted to hear something along these lines from the Fed: "The recent rise in rates is counter to Fed policy, and if necessary, further actions will be taken to keep them low." But that's not what Bernanke gave the market. While the Fed didn't promise to raise rates soon, Bernanke seemed unconcerned with the recent rate climb on the 10-year Treasury. This aloof attitude signaled that higher rates are here to stay.

Rather than reassuring the market on Wednesday, Bernanke's comments pushed rates even higher with his disregard for the situation. In a matter of two months, the 10-year Treasury has climbed 76 basis points (0.76%), from 1.65% to 2.41%. In his press conference, Bernanke attributed the increase to three factors: stronger markets; anticipation of Fed policy; and additional unknown factors. The key takeaway here is that the Fed believes that the prime catalyst for the rate increase is factors other than policy anticipation. If the rise was the result of policy anticipation alone, the Fed could send rates down by simply saying so. Since that's not the case, corrective action from the Fed is much less likely.

Furthermore, Bernanke dashed the hopes of more accommodative policy in other remarks during his press conference. He said that the low level of inflation is only "transitory" and should move back up to the 2% area by itself – meaning the Fed will not take any action to push it toward the 2% mark, as was previously suggested in recent FOMC minutes.

On top of this, Bernanke described the Fed's strategy for the eventual reduction of its easing policy. The details aren't what shook the market – there was nothing huge and no change in direction. This lack of change is exactly what scared the market. The Treasury market is in a different place than it was several months ago. We're now in an environment of rising rates, yet the Fed's policy remains the same.

In a sense, by the Fed taking no action in light of higher rates, the Fed has taken a major step in signaling the end of low rates. The Fed is telling the market that it accepts slightly higher rates, and it won't do anything about them. What we're experiencing now is not the result of some unforeseen events. We are just stepping back in to the real world – a place where interest rates are zero forever. That doesn't mean the market is all downhill from here, but the era of easy gains is winding down.

Is It All Bad?

When there's red numbers across my brokerage account – it's hard to say this – I'm pretty happy with what's happening in the market. Rates were inevitably going to rise; it's just happening sooner than most people expected. Whether they rise tomorrow, six months from now, or three years from now, the process was going to hurt. In fact, the longer one puts off higher rates, the more painful the eventual move up. Personally, I'd rather take a little pain now than have my portfolio beaten beyond recognition later.

Hoping the Fed will promise yet more stimulus is only delaying the inevitable, and that doesn't get us anywhere. Even though the Fed would like to keep rates low forever, it can't do so – this had to happen.

Another reason to see a silver lining is that things are tough in the market, but they could be a lot worse. Many investors envisioned absolute terror at the first sight of higher rates. Yes, it's pretty scary right now, but in comparison to Lehman in 2008, this is a cake walk. The DJIA is below 15,000, but I'd be surprised to see a dip below 14,000 soon. If the ten-year Treasury could move this smoothly to around 5% – as will eventually happen – we should consider ourselves fortunate.

Lastly, we should be thankful for the clear wakeup call – particularly for yield-seekers. The spike in rates has deflated small speculative bubbles in a number of yield instruments. Long- and intermediate-maturity bond holders were rudely awakened, but other sources of yields took major hits as well, such as REITs and utilities, which have been down over 10% in the last two months.

To some that sounds horrible, but higher rates are doing those investors a favor – this is officially fair warning of things to come. Personally, I'd rather take a 10% loss on a utility stock now than take an even bigger loss when the Fed pulls rates higher. The same goes for bonds. If you haven't already gravitated to shorter-term maturity bonds, it's time to seriously consider it. The party isn't quite over yet for long-maturity bonds, but the bartender is making the last call. It's time to get out of the bar before you get kicked out.

So why are the Fed and Bernanke so quiet on this recent rise in rates? In many ways, it serves them well. On the one hand, the Fed wants lower rates to stimulate the economy. On the other hand, if the Fed does plan to move rates up in mid-2015 as it promises, then this is a good first step. All things considered, rates have moved upward with minimum pain. The Fed only needs to move them a bit more in mid-2015 – hopefully again with minimal pain.

If the Fed pushes rates back down, it will just have to pull them back up again in the near future, should things go according to plan. Sure, for the time being the economy would get a little more stimulus, but only at the price of more pain in the near future. If the Fed pushes rates down by 0.76%, it eventually has to pull them up again by the same amount. It's a choice between two options: a little pain now from higher rates and a little more pain in mid-2015; or a lot of pain in mid-2015, as rates would rise in a single big push rather than incrementally.

In short, the Fed is having its cake and eating it too. It can keep its policies exactly the same, while letting the market drive rates up slightly to drive some of the speculation out of the market. In many ways, this has been extremely good fortune for the Fed's long-term goal of exiting QE.

In the long run, higher rates are good for us – we can't stay in a zero-interest world forever. However, the market has become so conditioned to the permanent stimulus that even these slight rate increases are sending shock waves across Wall Street. What many people forget is that this is what needs to happen, what is going to happen, and what cannot be stopped. Personally, I'd rather start feeling a little bit of the pain now rather than jumping off a cliff in 2015.

Instead of seeing May and June as rough months and crossing my fingers for yet more stimulus, this is some of the first signs of normality in the stock market for a long time. Sure, normal doesn't feel so good in our brokerage account, but it's a little red now or a lot of red later. Take your pick. The former sounds better to me.

Preparing for the Worst

Recapping the week's events is one thing – taking steps to protect your portfolio is another. Make sure to keep up with our latest big-picture views in The Casey Report. Also, in Miller's Money Forever, we already took steps to protect ourselves from rising rates. In recent issues, we placed a stop loss on our only intermediate bond fund, held on to our short-maturity funds, and sold our only REIT for a 20% gain – literally a day prior to the REIT market beginning its slide. Furthermore, our picks over the next few months will be focused on sources of yield in an environment where rising rates hurt common yield solutions, such as bonds or utilities. For example, our latest pick is a diversified fund with a 3.7% yield and very little sensitivity to interest rates.

Rates have started to rise. We have all received fair warning. Today is not the time to cross your fingers and hope that everything will be in the green and up on Monday. Right now you need to take action to rearrange your portfolio to this new reality. Check out a free trial of Miller's Money Forever today.

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Vedran Vuk graduated with a BBA in Economics from Loyola University of New Orleans. Currently, he is pursuing a M.S. in Finance at Johns Hopkins University. He also spent time on a PhD. Economics program. His publications include academic journal articles, book chapter contributions, newspaper columns, and online articles. Prior to Casey Research, he worked in think tanks, government affairs, and corporate governance. Utilizing his experiences with academics, Washington politics, and financial knowledge, Vedran’s analysis often seeks to find the mid-point between these different areas.
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