Smith: Tempering Taper Tantrums

November 25, 2013

How to help cooler heads prevail when the Fed really does start to taper.

This article is part of a regular series of thought-leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Bob Smith, president and chief investment officer of Austin, Texas-based Sage Advisory Services.

Rarely do investors get the type of opportunity we have today to prepare portfolios in advance of an imminent market-moving event.

Although people may disagree about the timing, consensus says the Fed will begin tapering its asset purchase program in the first half of 2014, assuming the economy continues along its current trajectory.

Tapering is about as sure a bet as you'll find in the markets today. So, given this likelihood, the question is, what would be an optimal portfolio allocation?

Again, we're fortunate insofar as we witnessed a rehearsal back in May when Chairman Bernanke's forward guidance shocked the bond market out of its complacency and triggered a 100 basis point spike in the 10-year U.S. Treasury rate.

We're crossing our fingers that investors have indeed learned from the mistakes many made in 2013 when they confused tapering with tightening. The two conditions are definitely not the same.

Tightening, such as the introduction of a policy that intentionally lifts the target Fed funds rate, is the equivalent of an economic head wind. Tapering, by contrast, is just a reduction of the current easy-money tail wind that, while marginally diminished, continues to stimulate the economy.

Yet so many investors who heard "tapering" in May assumed we were entering an adverse 1994-type interest rate scenario and quickly sold their fixed income. The results? Distorted asset allocations, loss of principal and the frustration of subsequent months in which cash holdings underperformed their just-recently exited fixed-income investments.

The good news is that investors will likely get the chance for a do-over with “Taper Tantrum, Version 2.0” next year. So let's plan for it now.

Three-Stage Tightening

We believe the transition from loose policy to tight policy will likely proceed in three stages:

  • We're currently in the first stage, which includes both the anticipation of tapering and the actual tapering itself.
  • The next stage will unfold as the much-hoped-for positive U.S. and global economic fundamentals rise in importance to eclipse the Fed as the dominant driver of the markets.
  • The third stage will likely begin when central-bank tightening—read, a higher Fed funds rate—in the U.S. and abroad becomes a real concern.

 

1_The Three-Stage Policy Transition

 

 

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