What's next for funds when Fed stops buying bonds?
NEW YORK (AP) — In less than three weeks, a big change is nearly certain for investors. Few will be surprised, but some will be nervous.
On Oct. 29, virtually all economists expect the Federal Reserve to announce the end of its program that bought bonds every month in order to boost the job market. The purchases are widely credited for fueling price increases of all kinds of investments.
Investors have had a lot of advance notice that the end is coming, and the hope is that the announcement won't cause big markets swings given all the time they've had to prepare. Many mutual fund managers say their bigger concern is when the Fed will start raising short-term interest rates, which the central bank has said won't be for a "considerable time." Rising interest rates would knock down prices for bonds, and it could also sap demand for stocks. Most managers expect the first rate hike to happen next year and for it to have a bigger impact than the end of bond buying, which is also known as quantitative easing or QE.
But some fund managers say this time may not be different from past instances that QE has ended, and they're preparing to see jolts in both the stock and bond markets. That's what happened in 2010 and 2011.
"Every time that the Fed has ended QE, rates have gone down, and stock prices have gone down," says Jim Keegan, portfolio manager of the $1.1 billion RidgeWorth Total Return Bond fund (CBPSX). "That seems to be holding true again."
At least be prepared to see higher volatility, says Wasif Latif, who oversees $28 billion in mutual-fund assets at USAA Investments, invested in everything from corporate bonds to emerging-market stocks.
Notwithstanding some recent wobbles, it's been a remarkably calm climb for stocks in recent years. The Fed's bond-buying program helped the stock market not only to surge but to do so in nearly uninterrupted fashion, even when the economy was improving only modestly. The last time investors saw a 10 percent drop for the Standard & Poor's 500 index was three years ago.
But this week's bumpy ride -- where the S&P 500 sank 1.5 percent Tuesday, only to jump 1.7 percent Wednesday and then fall as much as 2.1 percent on Thursday -- may be a preview of things to come after QE ends.
To be sure, conditions are different from past instances when the Fed ended QE programs. The economy is stronger, and the unemployment rate is at its lowest level since 2008. The central bank has also been steadily tapering the pace of its monthly bond purchases since January, down to $15 billion from $85 billion, and investors have already had their chance for a first reaction given all the advance notice.
While the Fed is almost certain to pull back soon on its stimulus, other central banks around the world are also still pushing the accelerator, which would give an upward push to stock prices. Most economists expect the European Central Bank and the Bank of Japan to keep up efforts to stimulate their economies.
Here's a look at how markets reacted when the Fed has wound down prior programs:
On March 16, 2010, the Federal Reserve announced it was wrapping up its first bond buying program, which purchased $1.75 trillion in mortgage-backed securities and bonds. By that point, the economy had begun growing again, and stock prices had made a big leap since hitting bottom in March 2009.
Stocks would go on to rise a bit more in the following month, but slumped soon after that. The S&P 500 lost more than 10 percent in less than three months.
The yield on the 10-year Treasury was at 3.83 percent at the end of March 2010, when QE1 ended. By October, it was below 2.40 percent. Yields fall when prices for bonds rise, and demand for Treasurys was rising due to worries that the economy wasn't strong enough.
Less than eight months after wrapping up its bond-buying program, the Fed launched a second round of purchases. The $600 billion program began in November 2010, and economists called it "QE2."
On June 22, 2011, the Fed said that it would buy the last of the $600 billion in bonds planned for QE2 by the end of the month and conclude the program.
By early August, the S&P 500 fell more than 15 percent. Losses were exacerbated by worries about the European debt crisis and the first-ever downgrade of the U.S. credit rating.
The yield on the 10-year Treasury fell from 3.16 percent on June 30, 2011 to below 2 percent just before Labor Day 2011.
A few weeks later, the Federal Reserve announced a program to buy $400 billion in longer-term Treasurys and sell an equivalent amount of shorter-term securities. The aim was to keep mortgage rates low and to help the economy, and it was meant to last only until the end of June 2012. Economists called it "Operation Twist."
— Operation Twist
In May 2012, as investors prepared for the upcoming end of "Operation Twist," the S&P 500 fell 6.3 percent. The next month, the Fed said that it would extend the program through the end of the year.
Before the deadline arrived, the Fed announced that it was starting a new round of bond buying. This round was dubbed as "QE3," and it's the one expected to end this month.