Fed Fake-Outs and Debt Ceilings
by Alfred Lee, CFA, CMT, DMS
Vice President, BMO ETFs
Portfolio Manager & Investment Strategist
BMO Asset Management Inc.
In this report, we highlight our strategic and tactical portfolio positioning strategies for the fourth quarter using various BMO Exchange Traded Funds. Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six.
• Once again, the U.S. debt ceiling has come to the forefront in terms of headline risk. A failure to raise the limit on the ceiling by the October 17 deadline would likely lead to a significant rise in market volatility and a potential downgrade of U.S. Treasuries. As a percentage of gross domestic product (GDP), U.S. debt is expected to hit 75%, more than double the 36% in 2007.
• Over the summer months, asset markets continued to drift lower on anticipation that the tapering would be announced at its September Federal Open Market Committee (FOMC) meeting. In anticipation of a reduction in the Federal Reserve Board’s (Fed) Large Scale Asset Purchase (LSAP) program, the rates market experienced a considerable uptick, especially on the long-end of the curve, putting significant pressure on bonds and yield oriented assets.
• Come mid-September, however, Fed Chairman Ben Bernanke surprisingly announced that there would be “no tapering”, citing the need for additional evidence of a lasting improvement in the economy. While markets bounced back on the announcement, the rally faded as we headed into October. Although the tapering has been called off for the time being, we believe the Fed has created uncertainty and hurt its credibility in providing guidance.
• Yields have stabilized since the last FOMC meeting, with the 10-year U.S. Treasury rate falling 23 bps to 2.62% since September 17. Canadian yields also experienced a similar alleviation, falling 22 bps to 2.55% over the same time period. Additionally, we saw yield curves flatten in recent weeks, taking pressure off of fixed income, especially longer dated maturities (Chart A).
• Assuming the debt ceiling gets raised, yield oriented assets look deeply oversold. Consequently, we anticipate potential gains in areas such as real estate investment trusts (REITs), emerging market debt and longer dated government bonds, political risk notwithstanding. Over the longer term, however, we continue to believe the market is becoming more cyclical, with economically sensitive areas outperforming, especially for U.S. equities. Over the mid-term, the inter-market relationships also suggest a strengthening economy, with equities and even certain commodities gaining relative to bonds.
• One concerning note is an indicator that we have addressed in the past. The NYSE Margin Debt Index, which measures the margin used to buy stocks on the New York Stock Exchange, recently reached an all-time high. Lower borrowing cost is an obvious reason. The concern, however, is the impact of rising rates on borrowing costs and whether the velocity of the rise may lead to a deleveraging event. As a result, even though we favour equities over commodities and bonds, it is important not to over-stretch towards equities (Chart B).
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