The United States Federal Reserve’s (The Fed) announcement on Thursday NZ time that it would look to reduce the pace of its massive $85 billion per month bond buying programme later this year and cease it toward the middle of 2014. This has caused some very strong movements in financial markets including interest rates, currencies and share markets both in the US but also globally.
The Fed’s bond buying program (often referred to as QE) was designed to reduce longer-term interest rates. It was successful with the 10 year US government bond rate falling as low as 1.6% in May. So the announcement that it would stop buying bonds has naturally reversed some of this fall with the US 10 year bond rising to 2.4% since the Fed started to warn markets that it may start tapering its bond purchases in May this year.
The impact on share markets and the $NZ has been in part due to a reversal of investors’ appetite to take on risk to enhance yield. Low rates on fixed income investments had encouraged investors to take on more risk by looking for higher yielding but higher risk investments, such as shares and the $NZ. A reversal of this risk appetite and yield seeking has created a perfect storm for shares such as Mighty River Power which was in part sold on its attractive yield. The fall in the value of the $NZ has also seen offshore investors look to exit their investments in NZ to protect the value of their investments in their own currencies.
Although the increase in longer term US rates was expected at some stage the impact on financial markets has been relatively sharp and has surprised many investors including the Fed. However, aside from a rise in very long 10 year interest rates a large part of the supportive economic investment environment has not changed in the medium-term. Short-term interest rates are still very low and the Fed forecasts that they will remain near zero until 2015 / 2016. Additionally, the reduction in bond buying will only incur if the expected improvement in the US economy and its employment rate eventuates.
Looking forward we continue to expect market volatility as the artificial level of longer US rates normalises and as investors appetite for risk takes a breather. However, the economic and investment environment still remains favourable with low short-term interest rates, low levels of inflation and an improving growth outlook. Additionally, market falls often impact investments which should not necessarily be impacted creating opportunities for active investors to buy good companies at more attractive valuations.
Disclosure: Milford Funds invest in Mighty River Power