The Fed Chooses To Punt

The Federal Reserve Board chose to do more of the same in September and will continue to buy bonds at a $1 Trillion annual pace.  All that hub-bub earlier in the summer about pulling back, now coined as tapering, well you can just forget that.  The Stock market is at recovery highs and why rock the boat?

Outgoing Fed Chairman Ben Bernanke appeared to have the right idea earlier this summer when talks of tapering came to the forefront.  The economy was moving ahead, though certainly not smartly, with stocks higher and unemployment lower.  With six months left on his tenure, why not work on your legacy?  Bernanke didn’t have to leave as the profligate Fed Chief; Bernanke could taper and at least begin to slow the annual trillion dollar Fed expansion.  Nah!  Never mind!

When it comes to kicking the can down the road, the Fed is the ultimate can kicker.  Accommodative policy…forever!  There is no rationality here; no amount of rationalizing will lead us to an answer.  Fed policy is what it is and no one can really explain why it is (or why it isn’t) getting results.  Evidently no one else at the Fed has any better ideas either.

Regardless of what one might think, doing well at investing is not logical.  We build narratives to fit what we want to believe and to support our investing actions.  Interest rates, and their direction, are always a case in point.

By buying bonds, and lots of them, the Fed’s goals since 2008 have always included keeping interest rates low as a means of stimulating the economy.  High bond prices, because of buying and more buying, mean low interest rates and until June 2012 lower rates is what we got.

Lower rates and the corresponding rise in bond prices also mean bond mutual funds generally perform nicely.  Nice that is until June 2012 for US Treasury mutual funds.  For municipal bonds this nice performance ended Thanksgiving 2012.

So what changed in June 2012 for US Treasury notes and bonds and what changed Thanksgiving 2012 for municipal bonds?  This is where your rationalizing should have ended, because there is no rational explanation as to why performance ended at those points in time.

For municipal bonds the turn didn’t seem to attract much attention until May and June, six months later, as the municipal market took one of its worst falls ever.  Just how bad the performance has been depends on the particulars of the bonds.  Long-term municipal bonds fell close to ten percent in May and June with intermediate bonds falling 5-7%.  With municipal bonds selling at yields as low as 1%, 2% or 3%, you can see how dramatic the fall was.

But of course it got worse for some.  Rather than stabilizing in price during the third quarter, municipal bond funds that invested in Puerto Rico bonds saw their performance continue to swoon, some approaching a twenty percent plunge since May.  If you use bond funds at all it is therefore very important to keep a sharp eye on your fund’s market values as bad can (and has) led to worse.

So obviously the narrative the Fed’s trillion dollar a year buying spree will keep rates lower and lower (or even just low) just didn’t hold water.  Rather than focusing on that narrative, perhaps we should choose another narrative and say the Fed’s bond buying will lead to higher inflation and higher rates.  Really?  Rather than dreaming up narratives to seemingly fit current reality, I have a better idea: forget the narratives.  The narratives will not help you with your investing.  In other words, I believe CNBC is a waste of your time.

My focus and as I have written over the past number of months should be your focus as well, is centered on the market.  Long periods of a one way market should lead you to look for a turning point, not lead you strengthen a narrative about why the past happened.  I looked to the Gold market for clues of a turning point in Bonds because Gold was the most recent asset class to peak.  Gold peaked in August 2011 but it wasn’t until March/April 2013 that Gold fell out of bed.  Lo and behold, Bonds peaked in 2012 and fell out of bed in May/June 2013.

Market action is important because we are now left only with the late topping action in Stocks and near-stock categories such as Junk Bonds.  Stocks might appear to be all the rage of late, but someone with a ruler can see that the broad averages today are at the same level as they were back in May.  Time has passed but the levels are the same.  This is important because Stocks tend to peak months (even a year plus) later than Bonds.  This is a tendency I respect.  I do not expect Bonds to say, oh, never mind, and resume their historic upward climb in prices; I do expect Stocks to follow Gold and other commodities as well as Bonds and trend downward.

I am of course just as interested in Municipal Bonds.  Detroit bonds had nicely followed the Fed’s preferred course of action by continuing to kick their own can down the road, until…the day they did not.  Detroit is interesting but I am even more interested in Puerto Rico.  Here in Texas you might not know the enormous role Puerto Rico bonds play in the municipal bond mutual fund and managed account business.  Puerto Rican bonds are exempt from state and local taxes in the US making Puerto Rican bonds quite popular for residents in New York (particularly New York City) as well as other income tax states such as VA, NC, MD, AZ, MA and PA looking for extra yield.

Whereas Detroit is a $17 billion bankruptcy and most of its debt is insured, what I like about the Puerto Rican barometer is they have $53 billion in debt, plenty of which is uninsured.  Yields on long-term Puerto Rican bonds doubled from 5% to over 10% and even bonds as short as four years have seen prices fall 10-15%.

Why did Detroit finally decide to file for bankruptcy after kicking the can down the road literally for decades?  Puerto Rico is looking to borrow an additional $2 billion and perhaps refinance their high rates.  Really?  Why did the market decide to tank now at $53 billion in debt…why not earlier at a mere $50 billion?

These are the games that managers of municipal bonds play.  Wherever the game of can kicking is played, one best beware.  As you can see, can kicking involves the biggest of the big in municipal bonds and certainly that is the case with the Federal Reserve and their balance sheet bloating policies.

Investors in mutual funds or any managed funds involve risks, and the worst risks are those that seem to be hidden until one day they are not.  Investors have been willing to play the game of kick the can down the road previously because no one was getting hurt.  This is no longer the case as even the boring municipal bond market is racking up serious losses.

The Gold market and now the Bond market has shown how bad can and does become worse.  I will continue to lay this out as the guide for Stocks as well as near-stock investments such as Junk Bonds.  What previously was described as buying opportunities for Gold turned out to be nothing but a trap, so far this is the experience for Bond market investors as well.