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The Roller Coaster Ride to "Normal"

by Thomas J. McCarrel, CFA, Vice President, Senior Portfolio Manager

 

Most of us prefer to get our rides on the roller coaster at the amusement park. This summer it appears that we are also going for a ride in the bond market!

The source of the volatility comes from investor concern regarding when the Federal Reserve will begin to reduce the $85 billion of bond purchases that they make each month and also when they will allow interest rates to move up from their artificially low levels to more normal historical levels. Investors hate uncertainty and tend to have knee jerk reactions when the predictability that they crave is not evident. This was evidenced over the past couple of months as the interest rate on the benchmark 10 year US Treasury bond rose sharply to over 2.6%. Since that jump there has been some recovery, primarily because the Federal Reserve has assured investors that they have not taken their foot off of the stimulus pedal. Realistically, investors know that sooner or later there will be a return to more “normal” historical interest rates. They just don’t want to go through the pain of getting there.

 

The official word from Chairman Bernanke is that the Fed will begin to taper back on the bond purchase program (also known as Quantitative Easing 3, or QE3) when the unemployment rate is less than 7.0%. Their next move will be to allow interest rates to rise after unemployment falls to a target rate of 6.5%. These levels are targets that do not stand alone. The members of the Federal Reserve Board of Governors also monitor a broad range of economic indicators that also play into the equation. Simply put, to get back to “normal”, the economy needs to demonstrate that it can grow without the stimulus that is provided by artificially low interest rates, and inflation needs to remain within acceptable ranges. The path is not clear and the uncertainty means that investors will continue to ride the rollercoaster throughout the summer.

 

At United Bank & Trust we have begun to implement a strategy to prepare for higher interest rates by moving to a more defensive fixed income allocation.  We expect that stocks will outperform bonds in the near term because the slow growth in our domestic economy is sufficient to support corporate profitability. Low interest rates and pain in the bond markets will also tend to push investors to consider paring back fixed income allocations to shift into growth assets to minimize interest rate uncertainty.

 

Contact your United Bank Wealth Management professional for guidance, and take your rollercoaster rides at the amusement park!