The Yellen Message!

Richard Croft
March 31, 2014
4 minutes read

The markets have been tepid lately as investors watch for signs of an improving US economy, a message telegraphed by Fed Chairman Yellen in her first news conference a couple of weeks ago.

If the data come in as Yellen expects – or more importantly as analysts think Yellen will interpret the data – traders may have to readjust valuations to match up with real economic activity rather than liquidity-induced euphoria. And while that can be a good thing, there will be a period of adjustment.

If the economy is really improving, as posited by Yellen, then the Fed will pick up the speed at which it ratchets down their bond purchase program (i.e. QE III). The markets will have to deal with an anticipated rise in interest rates, which would be bad for bonds and every other segment of society. That logic probably explains the trading range mentality of the financial markets over the past couple of weeks.

Some Fed watchers think that Yellen’s comments – notwithstanding the back peddling that went on after the fact – imply that short term rates could rise sooner than expected. That is sooner than the second half of 2015 timeline that most economists had been using to build out their GDP forecasts. But does that really matter?

Is there a scenario where QE-III ends, short-term rates rise yet medium and longer-term rates remain in check? Difficult to imagine unless you consider demographics! Is it possible that yield-hungry baby boomers will cause distortions along the yield curve in much the same way as the Fed has been doing for the past five years?

Consider the statistics that tell us baby boomers control about 70% of the wealth in North America. These same baby boomers are keenly interested in how much income they can generate from their portfolio rather than how fast they can grow their portfolio. I suspect in a rising interest rate environment baby boomers would be buyers of medium and longer-term bonds which may cap any surge in rates along that spectrum of the yield curve.

Imagine an economy where there is stability in medium and longer-term rates! Without interference from central banks, investors would have to focus on real economic activity. Low interest loans would be easier to come by for young consumers who have been working hard for the last five years repairing their balance sheets. Imagine the possibility for growth if US banks start loaning out some of that US $2.4 trillion in excess reserves that has been sitting on their balance sheets, the result of three different quantitative easing programs.

When real liquidity gets pumped into the real economy it will cause a tsunami of economic activity, probably at a time when investors are most fearful! Financial markets will surge from the ripple effect of unexpected economic growth, eventually reaching heights that will no longer be sustainable, but just high enough to entice smaller investors back into the markets after most of the gains have been made. I’m just saying!

If you can excuse the veracity of my message from the pulpit, allow me to offer a benediction. I simply do not believe that rising short-term rates will lead to a major crack in the economy. And while we may see a short term knee-jerk reaction in the financial markets… sentiment being what it is, I suspect it will be no more than a minor correction in an otherwise longer term bull market.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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