Who are these folks who keep insisting that the Federal Reserve will slow its bond purchases in September? Unless I’ve missed something, the press releases concerning Fed policy have explicitly stated that the central bank will maintain its zero percent interest rate policy for as long as the U.S. unemployment rate remains above 6.5% and price inflation remains below 2.5%.
Granted, quantitative easing (QE) is merely a component of the Fed’s efforts to suppress intermediate- to longer-term interest rates. What’s more, Chairman Bernanke has made a distinction between purchasing government debt at a slower pace and terminating the program. Nevertheless, who genuinely believes that unemployment is falling at a rapid enough clip to warrant a change in direction? Who actually sees the Fed’s inflation measure rising at a fast enough pace to justify a policy modification? Last but not least, why would Bernanke want to rock the apple cart in any shape or form prior to his January departure?
Perhaps ironically, the bond market has already thrown a tantrum at the mere suggestion that QE might be on its way out, albeit slowly. 10-year yields have jumped a full percentage point in anticipation of a September change. It follows that the Fed can probably sneak a modest reduction in its money printing and debt repurchasing without sending yields skyrocketing. Nevertheless, I doubt the Federal Open Market Committee (FOMC) will have the wherewithal to be aggressive at the same moment that Congress is fighting over the debt ceiling/government funding.
In other words, the greater risk to investors may be in holding firm to the belief that bond yields are going to soar over the next 6 months. Yields may waffle between 2.5% and 3.0%, but they’re not going to move higher than that. In contrast, there are many possibilities that could lead to 10-year treasuries yielding 2%-2.25% by year’s end. That’s right… lower. Falling yields (rising bond prices) could occur due to political impasses, renewed safe haven seeking or the Fed simply staying on its present path.
Even if the Fed attempted to begin exiting from its third round of QE in September, a long-awaited stock market correction of sufficient severity (10%-20%) and swiftness (weeks, not months) would usher in QE4. Prominent Democrats simply won’t permit any form of austerity to damage congressional prospects in the November 2014 elections.
Next page: Income ETFs
It follows that there are a number of income producers that are worthy of the current environment. For example, iShares Intermediate Investment Grade Credit Bond (CIU) may look like it is up against tremendous price resistance today. However, over the next 5 months through the end of 2013, I anticipate a total return of nearly 3.0% (1.25% interest combined with 1.75% capital appreciation).
Not enthralled by 3% through the end of the year? If yields do pull back as I anticipate, one might wish to tack on a bit more muni exposure in a taxable account. The iShares National Muni Bond Fund (MUB) is yielding about as much as corporate credit via CIU. That alone tells an investor to expect a bit of relative outperformance by MUB. I anticipate a total return of 6% through the end of the year (1.25% tax-free interest combined with 4.75% capital appreciation).
Another place to look for income is in the real estate investment trust arena. At the moment, most of them are moving in lock step with the direction of the 10-year U.S. Treasury Bond. While a fund like Vanguard REIT (VNQ) may not be able to reclaim its May highs by the end of December, a total return of 7% is certainly within the realm of probability (1.75% dividend combined with 5.25% capital appreciation).
Gary Gordon is president of Pacific Park Financial, Inc.