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The Federal Reserve (Fed) plans to start reducing its bond-buying program either in September or in December. Amid worries over tapering, the market raged on June 19, and it did again on August 14. The June 19 and June 20 market rout has a crucial investment implication. The two-day sell-off of both bonds and equities was not only outrageously massive but the movements of the two markets were coupled very tightly. Nearly every investor in the world, ranging from central banks and government-bond dealers to institutional and private investors, was confused. So, apparently, was the Fed itself.

The Fed's "Tapering" is not "Exiting," which is not "Tightening." Most discussions and articles, however, use these three different actions interchangeably, without an explicit time horizon, say in three months or in two years. This is the primary source of the confusion. As a result, most investors are easily inclined to believe that this rout is a signal for another market crash (or Black Swan) like the one in 2007-08. Their questions are:

· Is it a Black Swan case?

· Is the traditional 60-40 portfolio strategy obsolete?

· What are the likely market perspectives in the second half of this year?

Our research suggests that (1) there is no chance to see a Black Swan this time, (2) a 60-40 (or 50-50) portfolio strategy still works out nicely, and (3) the market in the months ahead would be volatile but stubbornly higher. This article focuses on the first and the third ones, saving the second one for the next installment.

Our analysis emphasizes:

  • The relationship between bond primary markets and bond secondary markets.
  • The time lag between adjustments in secondary and primary markets.
  • The shift of supply and demand curves in bond and equity markets.
  • The directly observed market data such as security prices and bond yields.

Most investors analyze mainly the equity market without linking the bond market explicitly. The bond market is more liquid and deeper than the equity market. Big market movements are usually initiated by the bond market. Our approach is to pull the bond market out of shadow, and put it on the stage. The nuance between our bond-market oriented view and other equity-market oriented ones is seen in this article.

Milton Friedman and Martin Feldstein

Milton Friedman explained the dual meanings of money, using two simple accounting items - a profit-and-loss statement and a balance sheet. This is the core concept of his monetary theory:

"The term money has two very different meanings…[One is that] money is a synonym for income or receipts: it refers to a flow, to income or receipts per week or per year…[The other one is that] money refers to an asset, a component of one's total wealth…Put differently, the first use refers to an item on a profit-and-loss statement, the second to an item on a balance sheet..." (Money Mischief: Episodes in Monetary History Harcourt Brace Jovanovich 1992. page 8. The highlights are mine.)

"Income is a flow; it is measured as dollar per unit of time. The quantity of money is a stock, not in the sense of equity traded on an exchange but in the sense of a store of goods or inventory, by contrast with a flow. Nominal cash balances are measured as dollars at a point in time [as in a balance sheet]…Real cash balances…are measured in units of time [as in a profit-and-loss statement]." (Money Mischief page 20. The highlights are mine.)

Justin Lahart of The Wall Street Journal posted:

"In a March speech, Fed Vice Chairwoman Janet Yellen…pointed to showing that it is the amount of 'stock' of bonds the Fed holds that matters for long-term rates, rather than the pace, or flow of purchases…Under the stock view, that should push rates higher. But apparently not by as much as has lately been the case. Mr. Bernanke remarked that the Fed is 'puzzled' by how far long-term yields have risen since he put the possibility of reducing bond purchases… in late May." ("Bernanke's Bond-Buying Paradox for Markets" The Wall Street Journal June 20, 2013. page C10. The highlights are mine.)

Martin Feldstein, who is a Harvard Professor and the Chairman of the Business-Cycle Dating Committee at the National Bureau of Economic Research (NBER), urged the Fed to taper as early as possible to correct the distortion incurred by the Large-Scale Asset Purchases (LSAP) (or Quantitative Easing) program:

"The Fed is also understating the impact of its tapering plan on interest rate. Mr. Bernanke has made it clear that he believes the level of long-term interest rates depends on the total stock of bonds held by the Federal Reserve, and not on the monthly rate of purchases." ("The Fed Should Start to 'Taper' Now" The Wall Street Journal July 2, 2013 page A13. The highlights are mine.)

A Flow versus A Stock

A "flow" and a "stock" are two key words highlighted in the above three quotations where Milton Friedman, Fed Officials, and Martin Feldstein used. A "flow" is measured in units of time, and a "stock" at a point in time. In other words, a "flow" refers to an item on a profit-and -loss statement, and a "stock" to an item on a balance sheet. Why do they dwell on these two words to explain money or the Fed's tapering? Because they explain the relationship between income (or deficit) and asset (or debt), and, more importantly, the adjustment loop and time lags to recover an equilibrium when one of them or both would move away from an equilibrium. Therefore, these two concepts have been used in macroeconomics, in monetary theory in particular, for a long time.

A "Stock" (Asset or Debt) Market versus A "Flow" (Income or Deficit) Market

The current LSAP (or QE) program buys $85 billion of long-term bonds a month: $40 billion of mortgage-backed securities (MBS) and $45 billion of Treasury notes. The Fed hinted to reduce the purchases soon unless economic data would worsen than expected. Treasuries notes are issued in the Treasury "primary" market where Treasuries are sold to cover any budget deficits. In the Mortgage "primary" market, MBS are issued to finance mortgages. These primary markets are "flow" (or items-on-a-profit-and-loss-statement) markets

The existing Treasury notes or MBS are traded in the "secondary" markets where all accumulated Treasuries and MBS are measured at a point in time. The outstanding quantities of Treasuries and MBS were $9.2 trillion and $8.1 trillion at the end of the second quarter of 2011, according to Wikipedia. Both markets were huge in 2011, and perhaps the current sizes of them are bigger. Think about the relationship between the Treasury "primary" ("flow") market and the Treasury "secondary" ("stock') market. Every year the Treasury Department auctions various Treasury notes to finance budget deficits. Jeffery Sparshott of the Wall Street Journal reported:

"For the fiscal year ending Sept. 30, the Congressional Budget Office estimates a deficit of $642 billion, compared with $1.087 trillion a year earlier and the smallest gap since 2008's $458.55 billion shortfall."("Revenue Surge Thins Deficit" The Wall Street Journal August 13, 2013. page A1)

The rapidly shrinking deficits reduce the amount of Treasuries issued in the primary market. For example, if the Treasury Department auctions $642 billion, and Treasuries mature $1 trillion during the 2013 fiscal year, the "stock" of Treasuries in the secondary market is decreased by $358 billion at the end of September. Note that the size of the primary market - 53.5 billion a month - is a tiny fraction of the size of the secondary market -- $9.2 trillion. The Fed' tapering is to link to 53.5 billion. Do you see any big difference between a 45 billion (current purchases) and a 40 billion or 35 billion? To search the answer, let us check the data points.

Two Rounds of the Market Rout

There have been two clearly observable rounds of the market rout: since the Fed hinted its tapering plan on the $85-billion-a-month bond-buying program in May. After the Fed explained its tapering in more details on June 19, the rout started: The first round was between June 19 and June 24, and the second round was between August 14 and August 19, as shown in Table 1.

On June 19, the yield of the 10-year Treasury notes surged to 2.311% or a 5.74% gain, the highest level since March 2012. The S&P 500 Index finished the day down 22.88 or a1.39% loss at 1,628.93. On June 20, the yield jumped again to 2.419% or a 10.31% increase. The S&P fell again to 1,588.19 by 40.74 or a 2.53% down. For four days between June 19 and June 24, the yield shot up 15.50% and the S&P dropped 4.88%. This was the first round of the market rout.

The second round of the market rout happened a few days ago, which was less severe but a same pattern: The yield boosted again to 2.884% on August 19 from 2.715% on August 13. It was a 6.04% up. On August 22 (Thursday) the yield reached 2.936% intraday trading, the highest since June 2011.The S&P tumbled 2.88% to 1.646 from 1,694.16 for the same period.

Table 1: The 2013 Market Rout BY Tapering

The First Round

10-year Treasury

S&P 500

DATE

yield

Daily

Cumulative

index

Daily

Cumulative

% Change

% Change

% Change

% Change

6/18/2013

2.182

*

*

1,651.81

*

*

6/19/2013

2.311

5.74%

5.74%

1,628.93

-1.39%

-1.39%

6/20/2013

2.419

4.57%

10.31%

1,588.19

-2.53%

-3.93%

6/21/2013

2.514

3.85%

14.16%

1,592.43

0.27%

-3.66%

6/24/2013

2.548

1.34%

15.50%

1,573.09

-1.22%

-4.88%

The Second Round

10-year Treasury

S&P 500

DATE

yield

Daily

Cumulative

index

Daily

Cumulative

% Change

% Change

% Change

% Change

8/13/2013

2.715

*

*

1,694.16

*

*

8/14/2013

2.712

-0.11%

-0.11%

1,685.39

-0.52%

-0.52%

8/15/2013

2.755

1.57%

1.46%

1,661.32

-1.44%

-1.96%

8/16/2013

2.829

2.65%

4.11%

1,655.83

-0.33%

-2.29%

8/19/2013

2.884

1.93%

6.04%

1,646.05

-0.59%

-2.88%

Note: The percent change formula: 200*(B-A)/(B+A)

BND and VTI

Prices of bonds move in the opposite direction of their yields. To see more clearly the co-movements of bonds and equities during the two rout periods, two key components in my portfolios -- Vanguard Total Bond Market Index ETF (NYSEARCA:BND) and Vanguard Total Stock Market Index ETF (NYSEARCA:VTI) - are selected, as shown in Table 2.

In the first round (June 18 to June 24), BND and VTI shed 1.94 and 4.41 by a 1.65% and a 5.31 fall, respectively. BND declined 0.59% on June 19 and 0.91% again on June 20. It was really a very sharp slide for just two days. VTI sank 1.29% on June 19 and 2.51% again on June 20. It was what we have not seen for almost four years. Francesco Guerrera of the Wall Street Journal said:

"A case in point: last week's turbulent trading saw investors flee exchanges-trading-funds for both equities and bonds in equal amounts: $2.7 billion of net outflows each, according to ConvergEx. The exact number is a coincidence but the trend isn't." ("The Risks of One Mind" The Wall Street Journal June 18, 2013. page C1) (Here "last week" was the week of June 10 to June 14.)

Whenever investors see a unison movement of bonds and equities, meaning leaving the market to go to cash, they are scared. It's a clear signal of a market crash (or "Black Swan"). A safety flight to cash of bonds and equities is a necessary condition for a Black Swan but not a sufficient condition. Compared with the 2007-2008 market crash, this time is different in one important point: The economy is still growing now but it was in a "Great Recession" at that time. As a result, no Black Swan is expected now.

Table 2: Vanguard Total Bond Market Index ETF & Total Stock Market Index ETF

The First Round

BND

VTI

DATE

Index

Daily

Cumulative

Index

Daily

Cumulative

% Change

% Change

% Change

% Change

6/18/2013

81.99

*

*

85.33

*

*

6/19/2013

81.51

-0.59%

-0.59%

84.24

-1.29%

-1.29%

6/20/2013

80.77

-0.91%

-1.50%

82.15

-2.51%

-3.80%

6/21/2013

80.44

-0.41%

-1.91%

82.36

0.26%

-3.54%

6/24/2013

80.65

0.26%

-1.65%

80.92

-1.76%

-5.31%

The Second Round

BND

VTI

DATE

Index

Daily

Cumulative

yield

Daily

Cumulative

% Change

% Change

% Change

% Change

8/13/2013

80.53

*

*

87.92

*

*

8/14/2013

80.49

-0.05%

-0.05%

87.46

-0.52%

-0.52%

8/15/2013

80.20

-0.36%

-0.41%

86.16

-1.50%

-2.02%

8/16/2013

79.99

-0.26%

-0.67%

85.88

-0.33%

-2.35%

8/19/2013

79.76

-0.29%

-0.96%

85.30

-0.68%

-3.03%

Note: The percent change formula: 200*(B-A)/(B+A)

In the second round (August 13 to August 19), BND and VTI lost 0.96% and 3.05% respectively, as shown in Table 2.The falling rates of BND and VTI decreased to 0.96% and 3.05% (in the second round) from 1.94 and 4.41% in the first round, respectively, as shown in Table 3: VTI performed much better than BND between the end of the first round (June 24) and the first day of the second round (August 13) That is one reason why BND moved down less than VTI relatively. The other reason is the different market structures of bonds and equities.

Table 3: The Decrease Rate of BND and VTI

ROUND

BND

VTI

first

-1.94%

-4.41%

second

-0.96%

-3.05%

What really happened on June 19 and June 20?

The causes seem obvious for the sharp drop of both bonds and equities on June 19 and June 20: One is bond investors' exodus induced by their concerns about tapering and raising interest rates. The other one is equity investors to take profits when the equity market hit the multi-year or record highs recently. The sell-off was made, expecting some rescue measures of the Fed as before. The sell-off of the equity market is not unusual, but the sell-off of the bond market is unusual.

In the Treasury (and MBS) secondary market, some institutional investors or foreign central banks decided to sell some portion of their holdings. The Fed primarily purchases long-term Treasuries (and MBS) in the primary market, and holds them to their maturities. As a result, some big sell orders in the secondary market failed to match up by sufficient buy orders.

Any change in the quantity of supply or demand by other variables than prices makes the supply (or demand) curve shift. For instance, if the quantity of supply of long-term Treasuries increases by expectations of tapering QE or rising interest rates, the supply curve shifts to the right. The prices fall (or the yields rise) and the quantity increases. This was what happened in the Treasury secondary market recently. The stake in this market is usually big, say a few billion dollars.

If the expectations are well-anchored, the spiked yields may sustain, but it's doubtful this time. As shown in Table 1, the yield of the 10-year Treasuries jumped up 15.5% for just four days; it was too fast and too high to sustain because the current economic data points can't support it. The surged yields cannot restore their equilibrium instantaneously. If the Fed pumps more liquidity, the market would restore a new equilibrium promptly, by a shift of the demand curve to the right.

Without the Fed's help, there are two ways to correct it. One is a shift of the demand curve to the right (or more demand) or a shift of the supply curve to the left (less supply due to a favorable revision of expectations) or both in the same market, but it can't be expected because most big players are in the side line. The second way is a stream of yield adjustments in the primary market. The shape of the supply curve in this market is almost vertical because the amount of supply depends on deficits, not on prices. The overblown yields in the secondary ("stock") market shifts the demand curve to the right in the primary ("flow") market. The yields plunge, given the quantity. The quantities in the primary market, however, are just a fraction of quantities in the secondary market.

This adjustment takes a finite time rate - a few weeks or many months. This process was underway between the first round and the second round of the rout. What did the Fed do? The Fed was not in the secondary market. The Fed was in the primary market, but the Fed wouldn't buy longer-term Treasuries whose demand was boosted due to an enhanced term premiums of them. The Fed would buy instead relatively shorter-term Treasuries such as the 5-year Notes. "The term premium is the excess yield needed to compensate investors for the risk of purchasing one longer-term bond rather than a series of short-term bonds." (Andrew Foerster and Guangye Cao, "Expectations of Large-Scale Asset Purchases" Economic Review, Federal Reserve Bank of Kansas City, Second Quarter 2013, page 19)

The Fed Can't Blink This Time

Who is blinking now? It's the market, not the Fed because recent data points show a weak but steady economic growth with a stable inflation outlook. It's also because this time is a right time, perhaps one of the best opportunities, to start scaling down the Fed's four-year old easy-money policies before the leadership transition in January 2014. It's more importantly because the Fed can't afford to make the depressed market rebound with more stimulus. Since the 2007-08 financial turmoil, the Fed has made the market spoiled, by lifting the market whenever it downed deeply because the Fed couldn't allow the market to pull the fragile economy down further.

The exit strategies have been prepared for since 2008 when the Fed started the current stimulus policies. Tapering is just a small part of them. Tapering is just reducing the liquidity pumping speed. If the Fed can't win over the current market moves this time, it's more difficult to exit later. That's why this time is the time when the market should bend. The investment implication is that this time is one of the most profitable times to invest. It's the time to start depleting your cash holdings to buy both bonds and equities. The right vehicles are broad-based low-cost index fund ETFs, such as BND, VTI, Vanguard Extended Market ETF (NYSEARCA:VXF), iShares Barclays TIPS Bond ETF (NYSEARCA:TIP), Power Shares QQQ Trust ETF (NASDAQ:QQQ), Vanguard FTSE All World ex-US ETF (NYSEARCA:VEU), and Vanguard Materials ETF (NYSEARCA:VAW).

In a sense, the current easy-money policies are passive. If the Fed will start exiting (or mopping liquidity) and tightening (or raising interest rates), the Fed policies will become active and more dynamic. The Fed will have Permanent Open Market Operations (POMO) in addition to Open Market Operations (OMO). The OMO is a traditional policy tool. The only difference between OMO and POMO is the former deals over-night lending rates while the latter longer-term government bonds. We experienced POMO with the Operation Twist (or the Maturity Extension Program) in 2011 and 2012. The MET (or OT) is to buy longer-term bonds, by selling shorter-term bonds. The Fed is a seller in the bond markets with this program. As a result, the Fed will be almost everywhere in the whole spectrum of interest rates, ranging from the over-night lending rate and a reverse repurchase program (coming soon) to the longer-term government bond yields.

The Market Perspectives

In a very near term, another round of the market rout is unlikely because on August 27 (Tuesday) the market revealed decoupling the bond market and the equity market, triggered by the worsening situation in Syria, as shown in Table 4.

Table 4: The Market of August 27, 2013

DATE

BND

YIELD

VTI

8/26/2013

80.13

2.805%

38.21

8/27/2013

80.33

2.721%

37.22

% change

0.25%

-3.04%

-2.62%

Note: Yield = the yield of the 10-year Treasury Notes

BND (bonds) moved sharply higher 0.25% while both VTI (equities) and the yield of the 10-year Treasury notes (in the opposite direction of BND) moved lower 2.62% and 3.04% respectively. What happened? Perhaps a change in market valuations and expectations shifted both the supply curve in the equity market and the demand curve in the bond market to the right. There was a plunge of both the prices of equities and the yields of bonds simultaneously. It's really a welcome development.

In a short run, the market would be bumpy but still bullish although the debt-ceiling showdowns are looming in the coming months. The current four-and-a-half year old bull market is expected to hit its peak in 2015 when the Fed is likely to have a tough time to fight recession and inflation. The time horizon of two years or longer, however, is very murky. All we have to do, as investors, is to focus on a near and short run outlook, just eyeing on a long run.

Source: The Federal Reserve Doesn't Blink This Time, The Market Does