After the Fed shock, markets set for more turmoil

U.S.Federal Reserve Chairman Ben Bernanke addresses a news conference following the Fed's two-day policy meeting at the Federal Reserve in Washington. Credit: Reuters
U.S.Federal Reserve Chairman Ben Bernanke addresses a news conference following the Fed’s two-day policy meeting at the Federal Reserve in Washington.
Credit: Reuters

Fasten your seatbelts. And expect lots of turbulence.

If that was the message Ben Bernanke was trying to deliver when he said the Federal Reserve could soon start scaling back its massive stimulus program for the U.S. economy, it’s safe to say investors received it loud and clear.

In fact, the sell-off in stocks, bonds and commodities that rippled around the globe after Bernanke’s remarks looks to some like the dawn of a new period of volatile, disorderly trade – a stark change from the calm that prevailed since the Fed began its most recent bond-buying program last autumn.

“When market regimes shift, they rarely do so in an orderly fashion – look at equity prices collapsing at the end of the dot-com bubble or the height of the financial crisis,” said Stephen Sachs, head of capital markets at exchange-traded fund issuer ProShares in Bethesda, Maryland. “It usually gets violent. We’re going to face that in interest rates now.”

Indeed, the bond market is at the epicenter of the financial market earthquake that Bernanke unleashed. Benchmark yields, which Fed easing had driven to record lows, surged to near two-year highs and are expected to keep climbing as traders come to grips with the prospect of the Fed ending bond purchases by mid-2014.

The aftershocks have rattled markets from Tokyo to Sao Paulo, and assets that had been top performers plunged. U.S. credit markets were hammered, with the gap between junk bond yields and Treasuries hitting their widest so far this year, while global equity markets lost $1 trillion on Thursday alone.

The brute force of the decline caught some by surprise, since Bernanke warned in late May that the Fed could slow its bond buying later this year. Even so, watching long-term interest rates rise 0.4 percentage points for the week – the biggest move in more than 10 years – after trading for months near record lows was a wake-up call.

“People live in denial all the time,” said Kim Forrest, senior equity research analyst at investment management firm Fort Pitt Capital in Pittsburgh. “The thinking part of people’s brains understood that rates would have to go up sometime. But they weren’t ready to be told that reality starts now.”

That goes for companies who now face higher funding costs and investors who had borrowed money cheaply to trade.

Investors had been funding trades in riskier markets by borrowing in the stable, low-interest-rate U.S. debt market. But the cost to borrow rises with higher rates and with increased volatility – both of which appear to be here to stay, at least for now.

Dan Fuss, vice chairman of investment management firm Loomis Sayles & Co, which manages $191 billion in funds, said: “Leverage is coming out of the market. These market moves reflect that, but when you get sharp moves like this a lot of people get nervous. That can contribute to more selling.”

Bond investors hoping to play “follow the Fed” forever face an even more frightening reality. As Zane Brown, a fixed income strategist at asset manager Lord Abbett & Co noted, a return to a more normal level of interest rates would result in a zero total return over the next five years for investors benchmarked to the popular Barclays U.S. Aggregate Bond Index.

Investors pulled $15.1 billion out of taxable bond funds in the first three weeks of June, according to Lipper, a Thomson Reuters service. That is the biggest three-week outflow from the funds since October 2008, at the height of the financial crisis.

“HYPER-SENSITIVE”

All of this has left traders and investors scrambling to protect themselves in anticipation of a volatile summer.

Trading in interest-rate futures contracts spiked to a record in late May when Bernanke first broached the subject of winding down stimulus. It soared again this week, when some 12.8 million contracts changed hands on Thursday, according to CME Group, well above May’s daily average of 7.9 million.

Volume in S&P 500 index options rose to 2.3 million contracts on Thursday, a new one-day record, while overall options volume of 33.3 million contracts made it the busiest day since August 9, 2011, four days after Standard & Poor’s stripped the United States of its top credit rating.

Since Bernanke has insisted that winding down bond purchases depends on continued economic improvement, traders now have to assume nearly every economic data release will have the potential to whipsaw financial markets.

“Across the board, we have seen people paying up for insurance in the options market,” said J.J. Kinahan, chief strategist at online brokerage firm TD Ameritrade. “The market is going to be hyper-sensitive to anything that the Fed says, and the three major reports on employment, retail sales and housing will continue to dominate the eyes of the market.”

The CBOE Volatility Index, a gauge of anxiety on Wall Street, jumped 23 percent on Thursday to 20.49, the first time this year it has exceeded 20, an often-used dividing line between calm and stressed markets. It closed at 18.90 on Friday.

Signs of concern about high-flying assets like emerging markets can be seen in the options market, where more than 1.35 million contracts in the iShares MSCI Emerging Markets exchange-traded fund traded on Thursday – 82 percent of which were put options, generally used to protect against losses.

The Merrill Lynch MOVE Index, a measure of expected volatility in the U.S. Treasury market, rose to 103.7 on Friday; that index sat at 50 in early May, a multi-year low.

The uncertainty the Fed has sowed by telling markets they are on their own means the days of almost uninterrupted gains that have prevailed since late last year are over. And that brings problems of its own for investors and the market.

For one thing, violent price swings make investors more vulnerable to big losses, prompting them to sell assets simply to reduce their value-at-risk (VaR) levels, a statistical method for quantifying portfolio risk over a given period of time.

Rack up enough of these forced liquidations and it is not hard to see how a sell-off in one market can spread quickly to other assets and other parts of the world.

Bob Lynch, head of G10 FX strategy at HSBC, said this was a factor driving the bond and equity sell-off in late May “and could be an important input driving financial assets lower in the current environment.”

“It is too early to tell if the market reaction to the Fed is just noise or the beginning of a greater sell-off in U.S. equities,” said Mike Tosaw, portfolio manager at RCM Wealth Advisors, an investment advisory firm in Chicago.

“Over the course of the last month, we have been taking money off the table in the stock market and keeping the cash for the time being. Early next week, we plan to evaluate if this is a buying opportunity in stocks or if we need to run for the hills.”



News
Entertainment
Sports
Lifestyle
Local

NYPD looking for man they say assaulted elderly…

      The New York City Police Department is asking for the public's assistance in locating a Hispanic male 20's wanted in connection with…

Local

Three arrested after allegedly assaulting off-duty officer in…

Three men were arrested early Saturday morning after allegedly assaulting an off-duty officer at a Bronx bodega, and the NYPD is asking for the public's…

Local

Healthcare union creates vibrant West Indian Day Parade…

Volunteers worked almost around the clock through the weekend, putting the flashy finishing touches on hundreds of costume pieces 1199SEIU members will wear while marching…

National

Top 10 most hipster college campuses

Hipsters are everywhere these days. You can't walk down the anywhere anymore without seeing a pair of skinny jeans on a handlebar mustachioed 20-something, a…

Arts

Theater: Discouraging 'Poor Behavior'

Theresa Rebeck's latest off-Broadway play, about two couples sparring on a weekend getaway, repeats a few mistakes of her past.

Gossip

Chef Todd English arrested for DWI in the…

Celebrity chef Todd English is facing DWI charges after a traffic stop on Sunday.

Movies

Box office: 'Guardians of the Galaxy' is 2014's…

This weekend "The Guardians of the Galaxy" passed the fourth "Transformers" movie to become the highest grossing film of 2014.

Gossip

Spears back with controversial ex?

Is Briteny Spears back with Adnan Ghalib?

Sports

Novak Djokovic feeds off US Open crowd to…

Novak Djokovic isn't a native New Yorker, but he sure knows how to use the U.S. Open crowd to his advantage.

NFL

Odell Beckham still 'weeks away,' Tom Coughlin angry…

Giants head coach Tom Coughlin has fought a losing battle against the media all preseason over the status of wide receiver Odell Beckham Jr.

NFL

3 things we learned in the Giants preseason…

The final score didn’t matter — a 16-13 win by the Giants — but it would’ve been nice to finally see Big Blue’s new-look offense get on track.

NFL

NFL Power Rankings: Seahawks, Broncos, Patriots, 49ers start…

NFL Power Rankings: Seahawks, Broncos, Patriots start at top

Education

These college students think breakfast is the most…

  It should be no surprise that the city that never sleeps is also home to the most students who like to order food in…

Sex

When it comes to dating, height matters

Does a man’s height really matter when it comes to dating? Unfortunately - according to a new study - the answer looks like it’s yes.…

Travel

10 free apps to make traveling easier

Finding the nearest bathroom, calculating currency exchanges and locating your departure gate must have been difficult for travelers of previous generations. But we wouldn't know,…

Travel

How to get a seat upgrade to business…

It used to be much easier to upgrade your coach seat to business or even first class, but rigid rules and tighter schedules have made…