Sunday, June 7, 2015

June 7, 2015 Wrecking Ball

Risk/Reward Vol. 269

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

“I came in like a wrecking ball

All I wanted was to break your walls

All you ever did was wreck me

Yeah, you, you wreck me”---lyrics from “Wrecking Ball” sung by Miley Cyrus

“There's no way out of this dark place

No hope, no future”---lyrics from “No Way Out” sung by Phil Collins

“Need a little sweetness in my life

Your sugar! (sugar!)
Yes, please (yes, please)”---lyrics from “Sugar” sung by Maroon 5

If, in the future, you ever doubt the influence that the European Central Bank (ECB) and the Federal Reserve have on the financial markets just remember this week. On Wednesday, ECB President Mario Draghi’s offhand comment that the ECB would not use quantitative easing to suppress volatility in Europe’s bond market caused a rout in the German Bund the yield on which jumped 32 basis points (from 0.57 to 0.89%) in just two days. That action rippled through the world bond market “like a wrecking ball/breaking down walls.” If I had not reduced my holdings in interest rate sensitive securities, it would have “wrecked me,” as the yield on the benchmark US 10 Year Treasury Bond (off which most income securities are priced) skyrocketed to heights not seen since October last year. (Remember a rise in yield equates to a drop in price.) If you want a cogent explanation watch Rick Santelli’s interview of Jeffrey Gundlach on Wednesday last which can be accessed through CNBC’s archived videos.

The rise in yields and the concomitant drop in bond prices continued on Friday on the heels of a better-than-expected jobs report. The report was so good, it increased the odds that the Federal Reserve will increase short term rates in September. Traders looked to shed low yielding bonds---and guess what---found very few buyers. The fewer the buyers, the lower the bid; the lower the bid, the greater the volatility. Thus the swings in the bond market have become huge. But why? As discussed in previous editions ( See Vol. 266 www.riskrewardblog.blogspot.com ), since the passage of the Dodd-Frank Act in 2010, major banks, which used to serve as bond market makers (buyers of last resort), no longer are permitted to serve that function. With no market makers in place, those wanting to sell bonds have no ready outlet. “There’s no way out of the dark place.” As the desire to unload low yielding bonds increases (as it will when the Fed increases short term rates), sellers will see “no hope” of avoiding a fire sale.

In today’s world and as seen this week, a significant downdraft in the bond market negatively impacts stock markets. The Dow Jones Industrial Average gave back most of its year to date gains, and the S&P 500 is now up only 1.65%. Why, you ask? As discussed in last week’s edition, much of the gain in stocks this year has resulted from stock buy backs and increased dividends, both of which have been fueled by massive borrowings (bank debt and bonds) by corporations taking advantage of the zero bound interest rates provided by central banks. If the central banks take away this “Sugar! Sugar!/Yes, please/Yes,please” borrowing will slow, buybacks will end and stock prices will drop. The anticipation of this occurring caused stock markets to drop last week.

As I have written in the past, rising yields are inevitable and in the long run should be welcomed by income investors such as yours truly. Unfortunately, the voyage there will be more volatile than in times past due to the absence of bond market makers. The next few months will be a breathtaking roller coaster ride for income investors especially those holding bonds where sellers will outnumber buyers; remindful of what those noted investors Maroon 5 warned:

“And like a little girl cries in the face of a monster that lives in her dreams

Is there anyone out there 'cause it's getting harder and harder to breathe.”

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