06/13/2013 10:47 AM

End of Cheap Money

Can the World Handle Higher Interest Rates?

By Martin Hesse, Anne Seith and Wieland Wagner

Photo Gallery: Central Banks up a 'Dead-End Street'

For the last five years, the world's leading central banks have been combatting the crisis with extremely low interest rates and vast bond purchases. Now the American Fed is breaking ranks, as it cautiously suggests a change in its policy -- sending the markets into turmoil.

Fuchinobe doesn't look like the kind of place where speculators have struck it rich. The commuter rail station near the Japanese capital of Tokyo is surrounded by drab apartment buildings and small single-family homes. But the neighborhood is also home to Yuka Yamamoto, 44, a star among Japan's so-called shufu toshika, or "housewife investors."

Yamamoto, a chemical laboratory worker by profession, has written about 40 books with investment tips for housewives. She makes television appearances and recently explained what she thinks about the boom that Prime Minister Shinzo Abe and Bank of Japan chief Haruhiko Kuroda have fueled with their relaxed monetary policy known as "Abenomics."

"I think Abenomics is great," says Yamamoto. The woman, wearing a white blouse and blue lacquered shoes, is pleased with herself. She said that she sold a large portion of her shares weeks ago and that she rode out the most recent mini-crash on the Tokyo Stock Exchange. After climbing by more than 80 percent since the end of November, the Nikkei index dropped more sharply in late May than it had since the 2008 Lehman Brothers bankruptcy. The wild swings have continued in June, with the Nikkei plunging 6 percent on Thursday.

Investors have also been shocked at the speed at which prices have risen and then collapsed on markets in Europe and North America recently.

The rapid changes were triggered by a man they sometimes call "Helicopter Ben" in the financial markets because he once flirted with the idea of throwing money out of a helicopter to fight the crisis.

While the Bank of Japan has just announced that it intends to pump even more money into the system, US Federal Reserve Chairman Ben Bernanke wants to slowly wean the economy off the cheap money that has intoxicated investors for years. That, at least, is what many investors believe.

And because activity in the markets is based primarily on expectations, stock and bond prices have fallen recently, while long-term interest rates have gone up, even though none of the major central banks has made any changes to their current, ultra-low prime lending rates. The monetary watchdogs are also continuing to buy government bonds and other securities in a big way.

Graphic: Cheap money.
To enlarge click here

No More Cash Infusions?

But investors are worried about withdrawal. They wonder whether the economies in the United States, Europe and Japan are robust enough to manage without cash infusions, or even with a somewhat reduced dosage.

When the financial crisis escalated in 2008, the Fed, the European Central Bank and other central banks began their cash therapy. Almost in lockstep, they reduced prime rates to close to zero and began buying up bonds on a large scale. To this day, the leading central banks have inflated their balance sheets with such practices to $10 trillion (€7.5 trillion).

But now something is changing. "For the first time, it looks as though one country, namely the United States, is leaving the crisis behind," says Ulrich Kater, chief economist at DekaBank. "And, also for the first time, a central bank, the Fed, is showing that it is thinking about normalization."

But will it also transform the thought into action? Can it even do that without the financial markets going haywire? So far, only the US economy has stabilized to a sufficient extent that a shift in monetary policy seems conceivable. And even there, the recovery is based on cheap Fed money and could collapse if deprived of this foundation.

'A Dead-End Street at Full Speed'

Even if the experiment works in the United States, a shift in Fed policy would also bring about consequences in Europe and Asia -- for banks, governments, investors and depositors. There, too, prices could fall and yields could rise. Crisis-ridden countries could once more run into problems securing financing, and banks could be burdened with new write-offs.

"The central banks have driven into a dead-end street at full speed. They can't turn around. All they can do is slowly apply the brakes," Jochen Felsenheimer says in his assessment of the situation. The Munich native is managing director at investment management firm Xaia, something of a tamed hedge fund that operates in accordance with stringent German rules.

But the central bankers also cannot continue along the current trajectory. "The policy of cheap money inflates asset prices," says Felsenheimer. The later the normalization occurs, the more painful it will be.

And because Bernanke also knows that, the Fed chief began a very gentle withdrawal process in May. "In the next few meetings, we could take a step down in our pace of purchase," Bernanke told the US Congress last month.

The Fed currently spends $85 billion a month to buy US treasury bonds and mortgage-backed securities. This has enabled it to keep mortgage rates low and reinvigorate the real estate market.

Merely a hint from Bernanke that the Fed could "take a step down" has caused 30-year mortgage rates to rise from 3.35 percent in early May to almost 4 percent recently. Rates on 10-year Treasury notes went from 1.7 to 2.1 percent. Although these numbers are still very low compared to historical rates, the development scares bankers like JPMorgan Chase Chairman Jamie Dimon, who said last week that while normalization is a good thing, it's also "going to be scary."

Bernanke is familiar with these fears, which is why he added that a restriction on bond purchases is not automatically the end of a relaxed monetary policy. It was his way of bringing calm to the markets while preparing them for harsher policies in the future.

'We Are Optimistic'

David Folkerts-Landau, chief economist at Deutsche Bank, thinks this is the right approach. "In light of the economic situation, an extremely expansive monetary policy involving securities purchases of this scope hasn't been justified in a long time," says the bank economist. "We are optimistic for the American economy and expect robust growth in the coming years."

That's why Folkerts-Landau expects the Fed to reduce its bond purchases from $85 billion to $60 billion this fall. "The Fed could also raise the prime rate in the second half of 2014." For this reason, he believes that the yield on 10-year Treasury notes could rise to 3 percent by the end of the year.

In contrast to Europe, the debts of banks, businesses and private households have declined in the United States, while government debt has increased. If interest rates went up, it would become more difficult for the government to reduce its debt. On the other hand, the American financial sector could handle a moderate rise in interest rates, says Folkerts-Landau. "There will be losses, but they will be distributed among many investors and will hardly affect banks and insurance companies. The financial system in the United States is much more stable today than it was in 2007."

Experts are more skeptical when it comes to Europe. "If the ECB stops its cash infusions, many banks in the euro periphery will be threatened with insolvency," says Jörg Rocholl, president of the European School of Management and Technology.

Banks are diligently repaying certain ECB loans, ECB President Mario Draghi stressed last week. But he also made no secret of the fact that "unconventional" measures for less favorable times are still being vigorously discussed at the ECB -- additional relief for banks that borrow short-term money from the ECB, as well as longer-term cash infusions. The ECB wants to continue its "accommodative monetary policy" for as long as necessary, Draghi explained. Indeed, the central bank has just extended its full-allotment lending policy to banks in the euro zone by at least a year.

The Japanese Model

But the Bank of Japan remains especially uninhibited as it continues to flood the markets with money. The central bank's new governor, Kuroda, is buying up more than 7 trillion yen (€54.5 billion) in government bonds each month. That's 70 percent of all new bonds.
Whether Japan will manage to emerge from its ongoing crisis thanks to Abenomics doesn't just depend on the central bank, which has already kept interest rates at close to zero since the mid-1990s without any visible success. The financial markets are waiting for reforms and have been disappointed by announcements to date.

Meanwhile, Japan's celebrity housewife Yamamoto firmly believes in the long-term success of Abenomics. And even if the United States restricts its loose monetary policy, which she expects it will do by the end of the year, it will be good for Japan. "Then the dollar will rise and the yen will fall. And that benefits Japanese export companies."

Just as Yamamoto predicts a favorable outcome for Japan, Deutsche Bank economist Folkerts-Landau argues that Europe could see similar benefits. "The euro will decline to between $1.20 and $1.25 by the end of the year, and it could even drop below $1.10 by 2015."

This could help exporters in the euro zone. But last week it was the dollar that fell, because investors still aren't quite sure when the shift in interest rates will actually happen and what its consequences will be.

This makes it difficult for investors to adapt to the changes. Munich investment manager Felsenheimer anticipates that prices will fall for all risk investments as US interest rates rise. "The markets that recently benefited the most from the glut of money will be the most strongly affected -- in other words, stocks, bonds and real estate."

According to Felsenheimer, yields on government bonds from Europe's debt-ridden countries, which have declined drastically in the last 10 months thanks to Draghi's bailout policy, will likely rise considerably again. "But investors would also pull money out of emerging economies," he says.

A sharper rise in interest rates would give risk-averse savers a reason to rejoice. Interest rates on instant-access savings accounts and fixed deposit accounts might finally go up, so that assets would no longer be consumed by inflation.

More of a Curse than a Blessing?

But for people buying real estate, rising interest rates will eventually pose a problem, because the low rates at which they have borrowed money in recent years are usually locked in for only five or 10 years. After that, the mortgages are generally renegotiated. "Many people don't realize how expensive this can get," says Dorothea Mohn of the Federation of German Consumer Organizations, which for some time has cautioned against the collective real estate buying frenzy to which Germans seem to have succumbed. "Too many loans are calculated on very narrow margins," says Mohn.

Even for life insurance customers, an interest increase, depending on how drastic it is, can be more of a curse than a blessing. Insurance companies have been complaining about low interest rates for years, because it forces them to invest most of their customers' premiums in relatively safe bonds, which are hardly profitable at the moment. On the other hand, these funds are also locked in at low bond yields for years. If interest rates go up within a few months, the investment strategists for the insurance companies have few options. This means that their customers also have little to gain from a boom in interest rates, at least in the short term.

Central bankers know what years of low interest rates and all the resulting cheap money have done to the markets. But eliminating these "sweets" again is difficult, says one expert, who isn't willing to rule out a scenario like the one in 1994. At the time, the Fed's decisions on monetary policy triggered a global tremor in bond markets. Within nine months, rates on German government bonds rose from 5.7 percent to just under 8 percent.

Jaime Caruana, general manager of the Bank for International Settlements, recently outlined what is needed so that central banks can finally regain the freedom to impose tighter monetary policy without shocking the markets: "Banks, households and firms need to redouble their efforts to deleverage and to repair their balance sheets, while policymakers must redouble their efforts to enact far-reaching reforms."

Progress in this area, he added, would also enable central banks to normalize their monetary policy. But how likely is that?

Translated from the German by Christopher Sultan

Copycat Capitalists

Alexander Friedman

13 June 2013

 This illustration is by Paul Lachine and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

ZURICH It is all too easy to envy China. At current growth rates, the Chinese economy will double in size in only nine years, raising an estimated 100 million people above the poverty line in the process.
Compare this to the major economies of the Western world. The eurozone’s GDP remains mired below 2008 levels, and the United States last enjoyed Chinese-style growth back in 1984, when gasoline was $1.10 a gallon and the first Apple Macintosh was rolling off the production line in California.
Given the West’s anemic performance in recent years, it is hardly surprising that envy of China’s economic dynamism has manifested itself in official policy. Recent examples range from direct market interventions (such as America’s effort to boost its automotive industry via the cash for clunkers program), to the British government’s attempt to reflate the United Kingdom’s housing market by guaranteeing mortgages under its Help to Buy scheme.
Even hitherto independent central banks have not escaped the creep toward state-sponsored capitalism. The US Federal Reserve has been gently encouraged to buy 90% of annual net issuance of US Treasury bills, effectively funding the US fiscal deficit and ensuring, via the resulting negative real interest rates, that businesses and individuals wishing to save, rather than spend, will lose purchasing power by doing so.
Ironically, Western countries are shifting to statism at the very moment that China appears to be heading in the opposite directionwitness its recent moves to liberalize its financial system. In just 10 years, the share of state-directed bank lending in China has fallen from 92% of new credit creation to less than half.
But copycat capitalism is not without risk; indeed, it is unlikely to end without someone getting scratched. The West’s efforts to emulate China are hindered by its inability to replicate the conditions of Chinese growth, such as labor mobilization, and its unwillingness to pursue practices such as the one-child policy. Thus, the West’s forays into state capitalism are more likely to result in the misallocation of capital, more in the vein of China’s vastly oversupplied steel industry but without the stellar headline economic performance of the national economy.
Coming from the other direction, China’s crawl toward a more market-oriented brand of capitalism also has potential pitfalls. We need look no further than its recent problems with so-called wealth-management products (WMPs) for evidence that reform intentions without adequate regulatory institutions can cause problems.
WMPs were commonly marketed to individuals as alternatives to deposit accounts. But the funds contributed were then invested in riskier assets that includedtrust loans” to companies such as property developers. The number of trust loans rose by 40% in 2012, which triggered serious concern among China’s authorities that WMPs could become the next financialWMDs,” because banks had strong incentives to make uneconomic lending decisions.
The subsequent state-directed WMP regulation put a brake on credit creation and sent Chinese stock markets plunging. Ultimately, however, the measures should enable China’s shadow banking system to continue to grow at a more manageable pace and in a more sustainable way.
There is a risk that the lack of growth in the West may make economic transformation in the direction of the Chinese model appear more urgent to its governments. But the Western economic model has brought about unprecedented standards of living. This achievement should not be dismissed because of one crisis, no matter how prolonged, and the economic model that produced today’s living standards should not be cast aside without careful consideration.
By contrast, China’s rapid growth should not obscure its need for economic change. According to the International Monetary Fund, at some point between 2020 and 2025, China will pass what economists call the “Lewis Turning Point,” at which a country’s vast supply of low-cost workers is exhausted and factors such as labor mobilization provide a diminishing contribution to growth. With smaller demographic and resource advantages in the coming years, the consequences of capital misallocation, unavoidable under a state-directed economic model, will come to the fore.
As China’s recent experience with WMPs demonstrates, economic change can expose old problems and create new ones. Ironically, China’s transformation from a state-directed to a market-driven economy may require the greatest amount of planning of all.

Alexander Friedman is Global Chief Investment Officer for UBS Wealth Management.

The Death Of Bonds Is Greatly Exaggerated

Jun 13 2013, 01:57

by: Eric Parnell

The bond bubble has burst and the 30-year bull market in bonds is finally over. Or so it would seem based on the flood of recent commentary from the financial media and press. While it has certainly been a most difficult stretch for bonds since the beginning of May, it is still far too premature to declare that the end is finally upon us for the bond market.

Don't get me wrong. I'm not suggesting that bonds represent an attractive long-term buy-and-hold investment the way they have for the past 30 years. With interest rates having already fallen to historic lows, the scope is limited for interest rates to fall much further. But this does not mean that rates are poised to immediately explode higher, either. After all, Treasury yields still remain in their long-term downward sloping trend that began all the way back in late 1981. In fact, they are still in a new lower trading channel that emerged immediately following the outbreak of the financial crisis.

(click to enlarge)

Thus, the declaration that the long-term bull market in bonds is over is hasty. Of course, today is not the first time that we have heard that the bond market is meeting its demise, as the post crisis landscape is littered with dire predictions on bonds that ended up missing the target as yields continued to fall. The following are just a few examples:

"When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."

-Berkshire Hathaway 2008 Annual Report

"This bubble may be the biggest one of them all. The Treasury bubble is about to burst."

-MarketWatch, November 2, 2009

"The bond market is in a bubble. And it's getting ready to burst."

-Money Magazine, June 4, 2010

"Gross was right: The bond bubble will burst."

-MarketWatch, October 18, 2011

"Signs indicate that Treasuries could be a bubble about to burst"

-USA Today, June 12, 2012

So the calls going out in recent days that the bond bubble is about to burst are certainly nothing new. Certainly, at some point Treasury yields will finally rise from their historically low levels. And perhaps the widespread calls will be correct this time, but far more evidence will be required to officially declare the bond market dead. Thus, it is worth exploring in more detail exactly what is going on in the bond market today and whether it is truly signaling that a major prolonged shift to the downside is imminent.

Putting Today's Treasury Yields In Context

Certainly, it has been a difficult road for bonds since the beginning of May. But it is important to put the recent pullback into its proper context. Yes, the last six weeks have been dreadful for bonds, but what is almost never mentioned is that the previous eight weeks were almost equally as tremendous.

After peaking at 2.09% on March 8, 10-year U.S. Treasury yields declined by nearly 50 basis points to 1.61% by May 1. Thus, the fact that 10-year U.S. Treasury yields have risen to 2.23% today is hardly a catastrophic move. Sure, it's a big move from May 1, but it only represents a 14 basis point increase from where we were three months ago.

(click to enlarge)

It is also worth noting where Treasury yields have been over the last few days. On the day before the release of the latest monthly U.S. employment report on Thursday, June 6, the 10-year U.S. Treasury yields had fallen back to 1.99%. And in the moments leading up to the release of the report at 8:30 AM on Friday morning June 7, these same yields were still at 2.04%. It was only after what was a generally lackluster employment report from an economic perspective that yields suddenly burst higher. I know attention spans have become alarmingly short in today's Twitter driven society, but I'm not inclined to declare the end of a 30 year trend based in part on a knee jerk market response that took place a few days ago. After all, if the jobs report turned out to be a disappointment, we could have just as easily seen yields break back below 2%.

(click to enlarge)

Treasury yields also remain in the better half of their post crisis trading range and have well tested support at current levels. In the aftermath of the financial crisis from late 2008 to mid 2011, 10-Year U.S. Treasury yields were trading in a range between 2.40% and 4.00%. It was not until the summer of 2011 when yields decisively broke below the 2.40% range en route to below 1.40% by the summer of 2012. Along the way, yields have successfully tested the 2.40% level twice before returning lower.

(click to enlarge)

Now, many might claim that these low yields would not have been achieved without daily U.S. Treasury purchases as part of the U.S. Federal Reserve's QE stimulus programs. To the contrary, history has shown that the exact opposite has been true, as lower yields have been reached despite these Fed bond purchase programs. For when the Fed has actually been buying Treasuries, yields have risen as institutions have been emboldened to take on more risk and more capital on net has moved out of bonds in favor of stocks during these periods.

But once these programs have ended, these same institutions find themselves clamoring back for the safety of Treasuries, more than offsetting the loss of demand from the Fed. And it was not until the Fed stopped purchasing Treasuries in the summer of 2011 that yields finally broke into their lower trading channel. Thus, for those worried that the potential Fed tapering of their bond purchase program may bode poorly for bonds, they may be upside down in their thinking, for recent history has shown the exact opposite to be true. And one has to look no further than Japan today to see clearly how the aggressive purchase of government bonds by the central bank can wreak havoc on bond yields and send them entirely in the wrong direction.

(click to enlarge)

Something Does Seem Different This Time

Just because bonds are still trading well within reasonable ranges does not mean that recent trends are not a cause for concern. Thus, closer scrutiny is worthwhile to determine if we are on the brink of a major breakdown in bonds or if the latest price action is simply just noise.

First, it should be noted that some notable technical damage has been sustained on the price charts of the major investment grade fixed income exchange traded funds.

Most notably, for the first time since the outbreak of the financial crisis, the composite iShares Core Total U.S. Bond Market ETF (AGG) has broken below its 200-day moving average.

(click to enlarge)

The downside price pressure has been widespread. Investment grade corporate bonds as measured by the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) have also broken this critical support level for the first time since early 2009.

(click to enlarge)

In lockstep with the sharp spike in mortgage rates in recent weeks, the iShares MBS Fixed-Rate Bond ETF (MBB) has also broken decisively to the downside.

(click to enlarge)

Perhaps most notable has been the sharp drop in U.S. Treasury Inflation Protected Securities, or TIPS, which have plunged swiftly lower in recent weeks on the iShares TIPS Bond ETF (TIP) to levels that are now well below recent support.

(click to enlarge)

Of course, we have seen the U.S. stock market as measured by the S&P 500 Index (SPY) break decisively below its 200-day moving average on a few different occasions during the post crisis period only to eventually claw their way back higher, so these recent breakdowns do not necessarily mean that all is now lost for bonds.

(click to enlarge)

But with this being said, it has not simply been a garden variety bond market pullback in recent weeks, as something more pronounced is clearly taking place beneath the surface this time around that warrants closer examination to determine if it marks the beginning of a sustainable trend or if the recent movements are just fleeting noise.

Dissecting The Recent Sell Off

A variety of suggestions have been put forth in trying to explain exactly why bond yields have been backing up in recent weeks.

Growth: One idea is that optimism over economic growth has finally compelled investors to move out of bonds and take on more risk. This proposition is flawed for several reasons. First, what exactly took place on the economic front in early May that would have suddenly sparked this notion among bond investors? They have had more than four years since the aftermath of the financial crisis to make this shift, so why suddenly would they be reacting now? And when examining the data, one could easily contend that the economic outlook is becoming increasingly uncertain, particularly with much of the rest of the world already slowing if not already in recession. Moreover, if this were indeed a shift driven by increasing optimism over the economic outlook, we would expect to see stocks thriving as bonds suffer. But following an initial charge by stocks in early May, bonds have actually been marginally outperforming stocks over the last three weeks despite all of the recent bond market woes.

(click to enlarge)

Taking this point one step further, one would particularly expect to see the economically sensitive cyclicals such as Caterpillar (CAT) and Freeport McMoRan (FCX) really jumping if this were the case. Yet both of these names have been trailing the bond market since bonds began pulling back several weeks ago.

(click to enlarge)
(click to enlarge)

Inflation: Another theme that has been suggested is that bonds are selling off over concerns about inflation. But according to the Bureau of Labor Statistics and the U.S. Federal Reserve, inflation pressures remain under control. If anything, pricing pressures are headed more in the disinflationary direction over the last year according to the official data. Taking this a step further, recent economic data has shown a net increase in inventories in recent months, which runs contrary to any notions about an inflationary build in pent up demand.

(click to enlarge)

Moreover, the velocity of money remains anemic, which is also helping to keep official inflationary readings firmly contained.

(click to enlarge)

Lastly, if the sell off in bonds truly were driven by inflation concerns, one would reasonably expect TIPS to outperform nominal bonds as investors seek to establish inflation protection in their bond portfolios. But the exact opposite has been consistently true, as TIPS have been hemorrhaging relative to nominal bonds for the entire duration of the bond sell-off since early May. And when reflecting back to early May, no major inflationary shock event occurred that would suddenly change the perception about aggregate future prices going forward either.

(click to enlarge)

Tapering: The recent sell off is not about the Fed potentially scaling back its bond purchases in the coming months. Or at least it should not be in part for the reasons previously discussed in this article. And if it is, it will likely present a particularly attractive buying opportunity for investors following any related sell off.

So if it's not enthusiasm over economic growth, it's not concerns about inflation and it's not related to the prospect of the Fed tapering its stimulus program, exactly what is it then? To find out, it is worthwhile to take a look back on the calendar to exactly when the sell off began in earnest.

Basically, the bond market as measured by the AGG peaked on May 2. And the sell off quickly picked up speed only a few days later. Since that time, the core bond market has traded low on 19 out of the last 28 trading days, a notable two-thirds of the time.

Clearly, a specific underlying instability exists that would cause the bond market to decline so persistently over this time period. In short, it smells like forced liquidation. And the source for this selling is most likely Japan.

Japan: After enduring an initial bout of wild volatility following the launch of the Bank of Japan's (BOJ) ultra aggressive monetary stimulus program in early April, the Japanese bond market exploded starting on May 7, which just so happens to effectively coincide with the peak of the U.S. bond market. And since that time, the rise in Japanese bond yields have shared a high correlation with the decline in the U.S. bond market.

(click to enlarge)

So what might be occurring in the Japanese bond market that is causing the spillover effect into U.S. bonds? While a variety of reasons could be cited, it is likely due to the implications associated with the Value at Risk (VAR) modeling approach used by many Japanese financial institutions that have massive holdings in Japanese government bonds. This is a topic that I recently discussed in the comment section of one of my recent articles. Over the last several years as the Japanese bond market volatility was relatively low, many Japanese banks were compelled to increase their allocations to Japanese government bonds in working toward a more stable VaR.

But following the launch of the BOJ's stimulus program in early April, the implied volatility associated with these bonds has exploded with concentrated spikes in interest rates on several occasions since. This sudden increase in Japanese government bond market volatility effectively forces institutions to sell these bonds in order to stay within their VaR model limits. Such selling can lead to even more implied volatility, however, which can force additional bond selling and result in a nasty feedback loop. So in order to protect against this outcome since many institutions hold massive quantities of Japanese government bonds, they can potentially opt instead to sell other assets to raise liquidity in order to offset the increased margin requirement associated with continuing to hold these Japanese government bond positions at higher volatility levels. And some of the highly liquid holdings that are likely on the list for sale is the broad range of U.S. Treasury and related investment grade fixed income securities.

This leads to an important related point. Liquidation pressures associated with Japanese bond market volatility first surfaced in the precious metals market including gold (GLD) and silver (SLV) back in mid April and subsequently spread to the U.S. bond market in early May. Thus, the next logical destination for liquidation pressures is the U.S. stock market, which is a risk that must be evaluated carefully by investors in the coming days.

In fact, this liquidation process may have already gotten underway on May 22. Only time will tell, but if the S&P 500 Index breaks decisively below its 50-day moving average on which it is currently perched at around 1610, the subsequent downside in stocks could be swift and severe. Thus, concentrating stock portfolios in high quality names such as ExxonMobil (XOM), McDonald's (MCD) and Utilities (XLU) that have demonstrated the ability to better withstand broader market selling pressure may prove particularly prudent if such a break were to occur.

(click to enlarge)

Bottom Line For Bonds

If Japan is indeed the root cause of why the U.S. bond market has been selling off so hard in recent weeks, it raises the obvious question. That is, should investors react and sell amid this liquidation?

The answer is no unless your time horizon is short or your risk tolerance is sufficiently low that recent volatility is no longer compatible with your personal profile. Otherwise, opting to sell in the midst of a liquidation phase is typically not good timing, as such phases often imply that securities are being sold indiscriminately and without regard to their underlying fundamental appeal. It should be noted, however, that depending on the pace and magnitude of the decline, sometimes it is prudent to stand aside from a position to wait until the selling pressure has subsided. For such phases often offer in their aftermath particularly good buying opportunities.

To briefly highlight this point, one can recall the experience of U.S. TIPS not long after the outbreak of the financial crisis. In the aftermath of the Lehman bankruptcy, TIPS were sold off violently by over 14% in a matter of just two short months. This decline had nothing to do with concerns over the creditworthiness of the United States government, as nominal U.S. Treasuries held steady and eventually took off like a rocket toward the end of 2008. Instead, the decline came about because Lehman Brothers was supposedly a major holder of TIPS and was forced to liquidate their massive supply into the marketplace. Of course, TIPS quickly bounced back once the liquidation pressure finally ended, and the pullback represented a particularly attractive buying opportunity for those at the ready.

(click to enlarge)

Returning to today and looking ahead, the broader outlook for bonds remains solid despite recent pressure. For until we see sustainable economic growth and renewed stability in global investment markets, and for as long as deflationary risks continue to outweigh inflationary pressures, the demand for high quality bonds issued in the United States is likely to remain strong.

One caveat to this point should be presented, however. If the Fed were to actually lose control of the bond market and yields began spiraling higher, then all bets are off including stocks and bonds. Otherwise, bonds have the strong potential to find their footing following this recently difficult period even though it may take some time to fully play out.