July, 2013
By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC

“What we’ve got here is failure to communicate.”

This famous line from the movie “Cool Hand Luke” captures the relationship observed between the markets and Federal Reserve Board in the second quarter of this year. In an attempt to articulate and clarify the current position of the Federal Open Market Committee, Chairman Ben Bernanke gave some guidance as to under what conditions the Fed would begin reducing the amount of stimulus being poured into the economy and eventually begin raising interest rates to a more normalized level. Somehow the markets were surprised by this information; markets don’t like surprises. Like what happens in many relationships (I say many, hoping it’s not just mine) what one party intends by their words is not what is understood by the other party. Bernanke’s attempt to clarify was interpreted as a significant change in Fed policy. This resulted in many stock and bond investors hitting the sell button, causing market values to drop and interest rates to rise. The final performance statistics for the quarter look like this:

Index 2nd Qtr
2013
Return
1 Year Return 3 Year
Annualized Return
5 Year
Annualized Return
S&P 500 2.9% 20.6% 18.5% 7%
Dow Jones Industrial Average 2.9% 18.9% 18.2% 8.6%
Nasdaq Composite 4.5% 17.6% 18.6% 9.4%
Russell 2000 – Smaller Companies 3.1% 24.2% 18.7% 8.8%
MSCI EAFE – International -1% 18.6% 10% -0.6%
Barclays US Aggregate Bond -2.3% -0.7% 3.5% 5.2%

Mr. Bernanke gets his fair share of criticism for pretty much every move he makes, some of which is warranted, others not as much. In his defense, he finds himself in a unique place in history, having made the decision that what a sick economy needed in order to avoid catastrophe was an ultra low interest rate environment and enough government provided liquidity to weather a recessionary storm until it could grow itself back to health. Several years into this process, the Fed is now working out the logistics of their exit strategy.

That’s one of the unique things about the financial markets, there is no definitive user’s manual with step by step instructions, like something you buy from IKEA. Whether you are Ben Bernanke trying to monitor the U.S. economy or an individual trying to keep a handle on your investment portfolio, everyone is forced to navigate according to their own philosophy, strategy, and instinct. Of course, even if there were a manual, there’s no guarantee people would use it. I once charred a meatloaf that I was supposed to be broiling because I didn’t read the manual which told me to leave the oven door ajar so as to avoid having the oven automatically entering in to self-cleaning mode.

In his ruckus causing speech in June, Bernanke revealed that the Fed will continue to let the economic data be the primary driver of when they will begin to “taper” (the next financial buzzword of which you will grow weary) their asset purchases and eventually raise interest rates. His statement characterized the U.S. economy as growing at a moderate pace with labor market conditions showing further improvement. The current unemployment rate sits at 7.6% as the following chart shows. The Fed believes that we are on track to have that drop to 6.5% - 6.8% by the end of 2014.

Last year at this time, the unemployment rate was at 8.2%, so the current 7.6% is obviously an improvement but the downside is the percentage of people participating in the labor force dropped from 63.8% to 63.4%.

While no one knows exactly how it will play out, especially because the results will be data driven, our research partners at Capital Economics outline the Fed’s unwinding policy this way:

“We currently expect the exit strategy will include five broad stages, including the tapering of the monthly asset purchases this September, the end of QE3 completely next June, a well-telegraphed first rate hike in March 2015 and the sale of some of the Fed’s holdings of Treasuries starting in 2017.”

The pace of these moves will accelerate if economic conditions prove better than expected or will be extended if economic conditions deteriorate.

Investors, again operating without a manual, are forced to navigate from an economy benefiting from significant

Federal Reserve assistance to one that is capable of standing on its own. At Castle, we have begun the process of reducing some of the interest rate sensitivity in our portfolios. We’re not giving up on holding bonds, just reducing the amount of bonds (particularly bond funds) that are likely to react negatively when interest rates rise and increasing our emphasis on owning ladders of individual bonds.

The following chart, which is not a performance chart, shows how some classes of bonds correlate to U. S. Treasuries. As conditions warrant, we want to hold more of the kinds of bonds that are less correlated to Treasuries and thereby less interest rate sensitive.

So far this year, the economy has been a mixed bag with some areas such as housing showing a welcome improvement while other areas like manufacturing showing weakness. Overall the final GDP number for the first quarter came in at 1.8%. While we are glad this number is positive, showing growth, the 20 year average is 2.5% demonstrating the continued sluggishness of our economic recovery.

At Castle, we will continue to be true to our philosophy of managing diversified portfolios while always keeping our clients’ best interests in mind. In closing, we are including a possible timetable, again from our friends at Capital Economics, which specifically shows what actions the Fed might take during the next couple of years. This is not a prediction, the actual events are likely to be different but it does give you a general idea of what a path toward normal interest rates might look like. Thanks again for allowing us to be your partners.

TABLE 3: POSSIBLE FED EXIT TIMETABLE

2013

July: QE3 continues – Fed buys $85bn of assets a month.

September: Start to taper QE3 – Fed buys $75bn of assets a month.

October: QE3 tapering continues – Fed buys $65bn of assets a month.

December: QE3 tapering continues – Fed buys $55bn of assets a month.

2014

January: QE3 tapering continues – Fed buys $45bn of assets a month.

March: QE3 tapering continues – Fed buys $30bn of assets a month.

April: QE3 tapering continues – Fed buys $15bn of assets a month.

June: QE3 ends. Language in statement says low rates for a “considerable time”.

September: Fed stops reinvesting maturing assets.

October: Language in statement changed to Fed will be “patient” in removing accommodation.

2015

January: Language in statement changed to accommodation will be removed at a “measured” pace.

March: Rates raised to 0.50%. Fed implements measures to drain liquidity from banking system.

June: Rates raised to 0.75%.

September: Rates raised to 1.00%.

2016

January: Rates raised to 1.25%.

March: Rates raised to 1.50%.

April: Rates raised to 1.75%.

June: Rates raised to 2.00%.

July: Rates raised to 2.25%.

September: Rates raised to 2.50%.

October: Rates raised to 2.75%.

December: Rates raised to 3.00%.

2017

March: Rates raised to 3.25%. If Fed decides to sell Treasuries it may start now.

June: Rates raised to 3.50%.

September: Rates raised to 3.75%.

December: Rates raised to 4.00%.

Sincerely,
The Castle Investment Advisors®, LLC Investment Team

                    
 
Disclosures: 
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.
This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. 
Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.