In a rare example of unity, governors of the U.S. Federal Reserve Board unanimously voted in early February to reduce the monthly bond-buying program by US$10 billion. Beginning this month, the Fed will purchase US$65 billion in Treasury bonds and mortgage-backed securities, down from US$75 billion in January.
But reducing the flow of money printing could have some unintended consequences for businesses and investors.
Given clear evidence that the U.S. economy is recovering and that growth, while tepid, is nonetheless steady, we expect the Fed’s policies to remain unchanged under new chair Janet Yellen, who officially took the reins last week.
We can also assume with some comfort that short-term interest rates, i.e., less than five years to maturity, will remain at exceptionally low levels until we see a substantive pickup in the employment data. Simply stated, although growth is picking up, job creation is nowhere near where it should be at this stage of a recovery.
Fed Actions Have Wide-reaching Consequences
Assuming the Fed continues along the tapering path, it is important to understand the dynamics that will impact portfolios throughout 2014. Some of these influences are obvious; others not so much.
You will recall that when the Fed telegraphed its intention to taper in June 2013, it had an immediate impact on interest rates. We saw an initial 0.5 percent spike on rates for five-year mortgages, and the yield on 10-year U.S. Treasury bonds swelled to 2.50 percent.
In the second half of last year, the 10-year rate continued to climb, closing 2013 near the 3.00 percent level. Naturally, we saw similar rate increases across the Canadian interest rate spectrum.
Higher rates are toxic for medium- and longer-term fixed income assets. But banks typically benefit from rising interest rates as their net interest margin expands. The net interest margin is simply the difference between a bank’s cost of capital and the yield on its loan portfolio.
Less Predictable Effects
Beyond the obvious factors, there are other less predictable impacts from tapering. For example, higher medium- to longer-term interest rates make U.S. bonds more compelling to global investors.
That attracts investors into the U.S. financial system, which causes the U.S. dollar to rise, sometimes significantly, as witnessed by the dramatic shift in our cross-border exchange rate, with the U.S. dollar rallying more than 10 percent against the loonie since September 2013.
The U.S. dollar has not moved as significantly against the euro, but even here we have seen an upswing since the beginning of the year. The concern, assuming that trend continues, is how it might eventually impact some of the peripheral states within the eurozone.
Currency Crisis Developing in Emergency Markets
On that point we draw your attention to the developing currency crisis in Argentina, Turkey, and the Ukraine.
Argentina’s currency has been in free fall since the country decoupled from what had been a fixed rate tied to the U.S. dollar. Argentina could simply no longer afford to keep up appearances, and the black market for U.S. dollars within Argentina is almost twice as much as the official exchange rate.
Turkey’s central bank bumped its benchmark overnight lending rate by 5 percent in one day, trying to stem the flow of capital out of the country. So far, the bump in rates has done little to quell concerns. Stability is critically important for Turkey as it seeks to gain full membership into the European Union (EU).
In the Ukraine, the hryvnia has fallen 4 percent against the U.S. dollar since November. Ukrainian bonds have also been hit hard, as the yield of Ukraine’s international dollar bond maturing in 2014 surged more than 3 percentage points to 9.3 percent, higher than the 8.52 percent yield on its 2023 bond.
US Debt Mountain
Closer to home, higher interest rates impact U.S. state and local governments trying to repay their mountain of debt. That problem appeared on the radar last week as investors came to grips with the real possibility of a default on debt issued by Puerto Rico, a self-governing American territory.
With the territory in recession since 2006—and facing a shrinking population—Puerto Rico has been aggressively tapping into the tax-exempt bond market to the point that its total debt has now reached somewhere between US$52 billion and US$70 billion depending on how you calculate the numbers.
Puerto Rico’s state debt burden as a percentage of personal income is about 89 percent, according to Moody’s (or about $85,000 per capita), compared with an average state debt to personal income ratio of 3.4 percent for the other 50 states.
Puerto Rico had been able to continue borrowing despite declining fundamentals, until Detroit’s bankruptcy raised the real threat of municipal and state defaults.
A default by Puerto Rico in and of itself would not be calamitous, but it would set in motion a more serious review of other municipalities and states seeking to raise money for new infrastructure projects. In a worst-case scenario, municipal bonds have the potential to become the next big crisis.
Growing Uncertainty
Investors were well aware the U.S. Federal Reserve could not continue indefinitely with quantitative easing and understood that exiting the program would create problems. What we are seeing now is the impact globally, weighed down by unintended consequences and unpredictable fallout.
What we know is that these dynamics will undoubtedly lead to increased volatility in the equity markets and more uncertainty among fixed-income investors. That’s why it’s more important than ever to focus on ensuring the correct balance between equities and income assets in portfolios to smooth out fluctuations resulting from unforeseen events.
Courtesy Fundata Canada Inc. © 2014. Richard Croft is President of R.N. Croft Financial Group Inc. This article is not intended as personalized investment advice. Investment vehicles mentioned are not guaranteed and involve risk of loss. This article has been edited from its original version.
