Three vital issues for investors remain uncertain as the Federal Reserve moves toward reducing bond purchases. Would this quantitative tightening mean that Treasury yields will increase or decrease? Will stocks work better if bond yields rise or fall? And, a related issue, does the relationship between bonds and stocks that has been maintained over the past three decades go backwards?
Few people share my first uncertainty, because it seems so obvious that if the Fed buys fewer treasures, the price will go down and therefore the yield will go up. It is the basic supply and demand, says the answer: Duh.
Certainly, it is true that the rest of the same, less bond purchases should mean a higher return. But everything else is not the same, because the Fed’s discussion of stimulus withdrawal shows a shift in mindset toward tighter monetary policy. A tighter monetary policy means less growth and inflation in the long run and therefore lower long-term bond yields. The balance between the impact of less Fed buying demand and the perception of a tightening of policy will determine whether yields increase or decrease at ten years and it is not obvious to me which way they will go.
On Wednesday and Thursday last week they offered an early test, as stock and commodity prices fell around the world after Fed minutes showed the central bank was heading for the downturn. buying bonds this year. After a brief increase, ten-year yields declined.
Early market movements also provide guidance on the second uncertainty: ending the purchase of Fed bonds can be bad for stocks. Still, we should be cautious about the ailment because of the uncertain interaction of two forces. Tighter monetary policy is bad for stocks, but stronger growth that usually pushes the Fed to tighten is good for stocks. Since 2000, this has shown a strong short-term correlation between rising returns and rising stock prices (although over the years, stocks have risen and fallen).