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Gail MarksJarvis: Stocks whipsawed by rising bond yields

McClatchy-Tribune Information Services

May 18, 2015


Most people donít attend dress rehearsals so they can figure out how a play might be enacted later.

But in these unusual times, the sharp volatility of the stock market lately may be helpful to observe if you want to make sense of the wild swings that may play out in investments in the months ahead.

For a short time Tuesday morning, the Dow Jones Industrial Average dove more than 150 points, and then recovered from most of the loss. If stock investors were trying to make sense of the plunge by examining stocks, they probably would have been flummoxed. Instead of the drama being driven by stocks, the stock market was forced down by bonds, or ó more precisely ó the fear investors had about rising bond interest rates.

And to make this scene particularly confusing, the impetus came primarily from Europe, where German bonds have been going through extreme gyrations since late April as 10-year bond yields have soared from near zero to about 0.8 percent. U.S. Treasury bond yields, apparently taking their lead from Europe, have also climbed sharply and the bonds have been losing value.

If this seems complex, it is. Bonds yields usually move along slowly, giving comfort to people that invest in them. But recently the movements have been sudden and dramatic. Analysts attribute the gyrations to investors reacting to unprecedented times, or the latest twist in six years of stock and bond market manipulation by central banks like the Federal Reserve. The Fed and central banks in Europe and Asia have been trying to resuscitate sick economies since the 2008 U.S. financial crisis by using highly unusual low interest rates.

Now, investors seem to sense the markets are at a crossroads and that interest rates dropped way too low for economic conditions. They think yields are climbing now because deflation seems to be easing in Europe and the U.S. is growing modestly. The Federal Reserve is expected to start raising interest rates in September or December.

"The reversal of global interest rates is sending shock waves through financial markets," said Jack Ablin, chief investment officer of BMO Private Bank.

For bond investors, this has meant losses on the safest of bonds, or bonds issued by governments. Ablin notes the 30-year U.S. Treasury bonds have lost 12 percent in value since early April as yields have suddenly increased to over three percent. (Prices of bonds drop as yields rise.)

And the adjustment is probably far from over.

"Massive liquidity fueled by overly easy central bank policies has pushed a multi-year bond rally to ridiculous levels, and the unwind is only beginning," said Ablin.

When central banks change directions on interest rates, bonds and stocks generally react. But if investors arenít prepared and thereís a dramatic switch in attitude in the market, the reaction can be extreme. In the last couple of weeks, central banks have made no change in interest rates. Yet, the bond market responded dramatically based on the assumption that change will be coming.

Some analysts assume that the reason the stock market moved so sharply Tuesday morning was because investors worried that large hedge funds, heavily invested in bonds, would lose money on their bond investments and sell stocks quickly to free up cash. They note that itís more difficult now for a large investor to sell massive amounts of bonds because of changes in brokerage firms since the financial crisis.

Historically, there have been times when sudden changes in interest rates have brutalized hedge funds which have been caught with investments behaving differently than expected. In the case of Long Term Capital Management, in the 1990s, a renowned hedge fund collapsed based on an incorrect bet on Russian bonds.

The stock market can also be affected in other ways as interest rates change. Certain types of stocks donít behave well when interest rates start climbing. Among those showing the strain recently have been utilities and real estate investment trusts (REITS). Because bonds have been paying so little interest the last few years, investors who needed income from their investments have been buying the high-dividend-paying stocks. But as investors assume bonds pay higher interest in the future, they prepare by selling dividend-paying utilities and REITs so they can buy bonds instead after rates rise.

Still, while stocks have been whipsawed lately by concerns about interest rates, the stock market doesnít always decline when interest rates first start climbing.

"The start of a tightening cycle typically causes some rise in volatility, but rarely a bear market," said BlackRock strategist Russ Koesterich.

At the first hint of higher interest rates, markets tend to react negatively for three months, he said. But then stocks rebound in six to 12 months.

Yet, Koesterich warns that investors focusing on these average results could be led astray by the current environment, which is unprecedented due to central banks trying to fuel growth through low interest rates worldwide. And he said when stocks are pricey, as they are now, the reaction of the stock market can be more extreme.

Koesterich notes: "This is not your fatherís tightening cycle."

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