When putting together an investment portfolio, you do not want your various investments to move up or down in tandem all the time. That is why one of the basic tenets in building a portfolio is to use non-correlated assets. Two broad categories of non-correlated assets are stocks and bonds. Stocks move separately from bonds and for this reason we like to have both in a portfolio. The current environment might appear to contradict this non-correlation of stocks and bonds, since both have lost value since May 9th. In fact, this does not disprove non-correlation; it just proves that current information has pushed both stocks and bonds downward. The question, therefore, must be “Why?” Looking at the bond market, we know that as interest rates rise, the value of bonds decreases. Lately, interest rates have begun to rise, in large part due to the uncertainty of the Federal Reserve Board (FRB) policy on buying $85 billion of bonds monthly, which has kept rates low until recently. The stock market moved down, reflecting the fear that a reduction in buying by the FRB would stall the economy, just as it was beginning to pick up momentum. My belief is that the FRB decided to test the markets by seeing what would happen if a reduction in buying bonds was to begin shortly (this summer or fall). The result has likely been to make them very concerned about such a possible change. The FRB meets next Tuesday and Wednesday, and will be discussing this issue and what they need to do. As the fears of reduction of bond purchases by the FRB have grown, the currencies of Japan and Europe have risen, which, if continued, would curtail any chance of growth for them. Emerging countries are seeing the value of their currencies decreasing, as investors avoid risk in favor of liquidity, creating a negative impact on their economies. The impact of a possible change in bond purchases by the FRB has already resulted in the bond, stock and currency markets preparing for the worst. It is my belief that the FRB is well aware of their role in leading the world out of an economic recession. With what has taken place in a very short period of time, the fragile recovery is headed in the wrong direction. For three years now, the FRB has been working to create momentum in the economy. I don’t think they are going to do anything to disrupt the goal at this time. Everyone wants to know, “What’s the deal?” The FRB must come out next week and say, with a great deal of certainty, that there will be no change in our buying of $85 billion each month until early next year at the earliest, or some similar indicator of their plans! A week from today we should have a pretty good idea of what they will be doing and for how long. If not, markets will continue to be volatile.
Ed Mallon
