Why Fed Tapering Should Worry Bond Investors

Quantitative easing has been a boon for stocks. The impact on bonds has been nearly as profound.
Through three rounds of the Federal Reserve’s bond-buying effort to boost a sluggish U.S. economy – QE1, QE2 and QE3 – yields on the 10-year U.S. Treasury bonds have risen a combined 98.4%, or an average of 29.5% annually. The S&P 500 has risen a combined 104.5%, an average of 31.4% annually.
In the combined 21-plus months between QE1 and QE2 and QE2 and QE3 – when the Fed left the U.S. economy to stand on its own two feet – stocks didn’t perform nearly as well. The S&P was up a total of 12.6%, or roughly 7% annually.
That’s a big difference. But 7% annual gains aren’t exactly a reason for investors to panic. A 42% loss, however, is.
That’s how much 10-year bond yields dipped in the gaps between QEs 1, 2 and 3. From March 31, 2010, when the Fed pulled the plug on its first round of quantitative easing, to Nov. 3 of that year, when QE2 was announced, 10-year bond yields decline 31.7%.
Then, from June 31, 2011 (end of QE2) to Sept. 13, 2012 (beginning of QE3), bond yields declined a whopping 44.4%.
The chart below shows the stark contrast between how bonds have performed since the recession during periods of quantitative easing versus periods with no Federal stimulus:
Bond yields dipped dramatically both times the Fed pulled the plug on quantitative easing. In July 2012, just before QE3 was announced, yields wallowed below 1.5% for the first time ever.
Wall Street reacted surprisingly well to the beginning of Fed tapering. Ben Bernanke announced last month that the Fed would be scaling back its $85 billion-per-month bond-buying program ever so slightly. Starting this month, QE3 will be reduced to a “mere” $75 billion a month in bond purchases.
Investors don’t seem to fear much these days. But given the consternation leading up to Bernanke’s monthly press conferences of late, it seemed that Fed tapering was the only thing capable of making Wall Street shake in its collective Armani shoes.
Once tapering began last month, however, investor fear subsided altogether. Stocks have risen another 3.5% since the QE3 scale-back was announced a month ago.
Perhaps it wasn’t tapering after all that investors feared. Maybe it was just the uncertainty surrounding tapering – and when it would begin. Because in the big picture, tapering is a good thing. It means the Fed thinks the U.S. economy is getting closer to being able to stand on its own, without artificial assistance.
Investors’ collective shrug of the shoulders since tapering was announced is a good sign that the bull rally for stocks may continue even after the Fed completely pulls the plug on QE3.
Bonds probably won’t be so fortunate. Bonds, after all, are precisely what the Federal Reserve has been buying. The Fed has accrued $4 trillion worth of mortgage-backed securities and Treasurys over the past five years. That kind of rampant buying tends to drive bond prices down. As a consequence, yields go up.
So it’s inevitable that when the Fed ceases its bond-buying program, yields will go down – at least for a while. They fell 32% after QE1 ended and 44% after QE2 ended. Expect more of the same once QE3 concludes.
When that happens, income investors will want to look elsewhere. With the Fed keeping interest rates near zero until at least 2015, CDs and money-market accounts will remain unsuitable alternatives to U.S. Treasurys. Dividend stocks and ETFs will remain the best place to find yield.
Fortunately, my colleague Steve Mauzy is constantly searching for yield. And in recent weeks, he’s written a number of articles on where to find it. Click here to read about his most recent find – an international stock fund with 6.9% yield.
Don’t fear the taper, bond investors. Simply start searching elsewhere for yield now … before the Fed completely puts QE3 to bed.

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