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The Feds Power Of Words

June 20, 2013 by Jon

Not much has changed in the past three years with the Fed and monetary policy. QE is still ongoing. Inflation is low. Unemployment is slowly falling. The Street is still trying to  predict the end of QE. So nothing has changed except for one word.

Taper  ta·per (tāpər): To become gradually smaller or less; slacken and finally stop. Bernanke’s beard tapered off.

Who knew one word had so much power. Since its introduction, dividend stocks have sold off and bonds have sold off. Asset bubbles aren’t talked about as much (those were the days). One word seemingly ended worries of three asset class bubbles while creating new risks for each at the same time.

One word!

Yet nothing has changed. QE continues. Inflation is too low. Unemployment isn’t low enough. Wall Street is still trying to figure out when QE will end. And now we have a name for it.

Despite all that Bernanke and his words have caused big changes since the first hints on May 22. You can see the difference in the top 50 S&P 500 dividend stocks versus the S&P 500 (the red line), though both were hit:

S&P500 Dividend ETF (SDY)
SPDR S&P 500 Dividend ETF (SDY)

Then you have the high yielding utilities ETF. An investor favorite over the past few years:

Utilities Select Sector SPDR (XLU)
Utilities Select Sector SPDR (XLU)

And another favorite in the dividend paying REIT ETF (notice a trend):

Vanguard REIT ETF (VNQ)
Vanguard REIT ETF (VNQ)

This all coincides with rising interest rates in bonds. Note that the bond market started moving earlier (a sign the bond market believes the economy is healing?):

10yr Treasury Rates
10yr Treasury Rates

But not everything was hit (it’s not the best example, but it makes the point and it’s not a recommendation to buy either):

iShares Core S&P Small Cap ETF (IJR)
iShares Core S&P Small Cap ETF (IJR)

The small caps weren’t alone. The ETFs for rising interest rates all performed similarly.

Despite all that we still don’t have a definitive answer to when. Though, Bernanke was kind enough to give an estimate of starting in late ’13 and ending in ’14. At least he confirmed that yesterday.

There’s only one problem. The Fed has been overly optimistic about economic projections. I’d bet on the Fed tapering later, not sooner. The economy is still healing but far from healthy. Inflation, or lack of, is too low. Deflation is more of a concern. A misstep now could lead to a recession or a bigger correction. Right now Bernanke is walking a fine line between perfection and disaster.

Of course, none of this is new. The Fed has used words over actions for years. Greenspan did it before Bernanke and Volcker before him. The market hangs on every word. Just watch every business channel the day of a FOMC statement. You’ll see several economists trying to decipher word changes from one month to the next. It’s amusing, really, the epitome of reading between the lines.

For now just wait and watch as the market throws its taper tantrum. Eventually sanity will return. Until then, you may not like the volatility but it brings opportunity if you’re patient.

The fact is the Feds words can have a big impact on the markets. Who knows what they’ll be next month. While QE is far from over, its impact is already being unwound with words.

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