The Cloud Of Interest Rate Uncertainty

Includes: SPY, TLO
by: AAII

Uncertainty over interest rates remains a short-term problem for the financial markets.

Wednesday's Federal Open Market Committee (FOMC) statement failed to calm the nerves of traders. Though traders were looking for more clarity, the June meeting statement only contained two notable changes from the May meeting statement. The committee altered its assessment of economic and labor market downside risks to "having diminished," from continuing to see those risks. The second change was the dissension of St. Louis Fed president James Bullard. Bullard thought a stronger defense of the committee's willingness to defend its inflation target was needed.

The immediate reaction by the bond markets was to push yields higher. The benchmark 10-year Treasury note now yields 2.42% versus 1.94% a month ago (May 21, 2013, close). Higher yields mean lower bond prices and there is already a knee-jerk reaction occurring in mutual funds. During the past two weeks, $24.3 billion has been pulled out of domestic bond funds according to the Investment Company Institute. The proceeds are not going into equities, however, with domestic stock funds incurring $4.8 billion in outflows over the past two weeks. Retail money market funds, conversely, have seen their assets increase by $15.5 billion over the past two weeks.

This said, I did observe more interest in dividend stocks than other income-producing instruments while I was at the Morningstar Investor Conference last week, a conference that attracts many money managers and financial advisers. It's admittedly an unscientific observation, but the dividend panel I sat in on was more crowded than the sessions about using a multi-asset approach for income and closed-end funds. I also noticed fewer attendees at a keynote session on bonds than there were at the opening session.

We do appear to be in a period of volatility marked by uncertainty and worry. This is hardly surprising given that we've enjoyed several months of relative calm in both the bond and the stock markets. Plus, I have yet to see downside volatility surface without uncertainty and worry accompanying it. Mr. Market is acting in a manner that is normal for him.

What is unknown is how much of the recent rise in bond yields reflects last year's overshot to the downside. It is possible that bond traders went too far in pricing in a continuation of loose monetary policy. To the extent they did, yields should rise. We also do not know how much interest rates will rise over the short term, much less over the long term. Bernanke emphasized yesterday that changes in the Federal Reserve's bond buying program will be dependent on how the FOMC's outlook for economic growth evolves.

It can be difficult to ignore the headlines and short-term market trends, but this is exactly what you should do. If money management firms and hedge funds staffed with economists, strategists and bond traders can't figure out the timing or magnitude of the next change in monetary policy, you should question your own ability to do so. And if you don't know the timing or the magnitude of the change, the best bet is to diversify. Not only can you hold a mix of domestic stocks and bonds, with funds, you can easily go overseas as well as Jesper Madsen of Mathews Asia explained. There are currency risks and potential tax issues, but doing so can help you reduce the impact of U.S. monetary policy uncertainty.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.