people donít attend dress rehearsals so they can
figure out how a play might be enacted later.
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.
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.
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.
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.
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.
reversal of global interest rates is sending shock waves
through financial markets," said Jack Ablin, chief
investment officer of BMO Private Bank.
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.)
the adjustment is probably far from over.
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.
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
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.
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.
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
while stocks have been whipsawed lately by concerns
about interest rates, the stock market doesnít always
decline when interest rates first start climbing.
start of a tightening cycle typically causes some rise
in volatility, but rarely a bear market," said
BlackRock strategist Russ Koesterich.
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.
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
notes: "This is not your fatherís tightening