As government agencies go, few have a bigger influence, of course, than the Federal Reserve, whose policies affect the prices of everything from a 30-year mortgage to a double skim latte, not to mention the outlook for economic growth, jobs and inflation. So when Federal Reserve Chairman Ben Bernanke signaled last year that the Fed would buy as much as $600 billion in Treasury bonds, it was bound to make waves among Fed fans and critics alike.
But now that the central bank's bond-buying binge is drawing to a close, even some of the Fed's toughest critics are nervous. The program which policy wonks call quantitative easing, but nearly everyone else calls QE2 was designed to keep bond prices high and interest rates low. It is credited with propping up the economy and, in turn, boosting the stock market. Technically, the Fed is in the midst of its second round of bond buying hence the 2 since the financial crisis struck in 2008. When the first round ended in spring 2010, both stocks and bonds tumbled.
Nevertheless, many experts regard a third round, or QE3, as highly unlikely. Some of them worry that in June, when the second round is scheduled to end, there could be a huge hole in the Treasury bond markets. "Who will step up to the plate on July 1 to buy them?" asks Bill Gross, the portfolio manager of the $240 billion Pimco Total Return fund, the world's biggest bond fund. Recently, he has been buying the debt of nations with emerging markets and, more dramatically, getting rid of all the U.S. government debt in his giant bond fund. "You don't want it to be like musical chairs," Gross says, "when the music stops and you're the one looking around for the last chair."
Tad Rivelle, the chief investment officer at Metropolitan West Asset Management, a fund company that specializes in fixed income, has been among the critics of the Fed's low-interest-rate policy. He thinks low rates have contributed to commodity-price inflation and will probably eventually lead to higher consumer prices in the U.S. QE2 has "distorted" the bond markets and kept Treasury bond interest rates "abnormally low," says Rivelle. Once the Federal Reserve's buying dries up, he expects long-term rates to rise and Treasury prices to fall, because bond prices and interest rates move in opposite directions.
Many experts predict stocks will be more resilient than bonds. Although equities tumbled after the Fed wrapped up QE1 in 2010, "the economy is much stronger now," says Joe Zidle, an investment strategist at Bank of America Merrill Lynch. The Fed's low-interest-rate policies "succeeded in turning skeptical investors into confident investors," he adds. The ultralow interest rates have made stocks a more attractive alternative to bonds, Zidle says, while rising sales and profits at many S&P 500 companies should sustain stock prices.
Zidle recommends focusing on areas of the market that could benefit from higher commodity prices and a stronger economy, such as technology, energy, materials and the industrials sector. If bond yields do creep up after QE2 ends, then bonds could start siphoning money away from stocks, Zidle says, but he doesn't see that happening until the yield of the 10-year Treasury is around 5 percent. Many strategists are predicting that the yield of the 10-year Treasury will rise to around 4 percent by the end of the year, up from 3.4 percent recently.
Strategists also say that if the end of QE2 leads to higher yields on U.S. bonds, that could prove to be a positive trend for the U.S. dollar, because it could attract more foreign investment. "I believe the biggest dilemma the U.S. will face is stopping the dollar from rising too much," says Jim O'Neill, the chairman of Goldman Sachs Asset Management. That might be disappointing to the many investors who have plowed money into foreign stocks and bonds, which often benefit from weakness in the dollar. O'Neill, a well-known fan of emerging-market stocks, has become less bullish recently on emerging-market bonds, which have gotten popular with some American investors who became fed up with the prolonged period of low interest rates. He says that if bond yields rise in the U.S. then some investors might move money back, and "that could be bad for emerging markets' debt."
To be sure, investment strategists aren't recommending switching to an all-stock diet. "Two of the biggest buyers in the Treasury market are going to go on strike this year," says David Kelly, the chief market strategist for mutual funds at J.P. Morgan Asset Management. While there's a chance they could change their minds, Bernanke and the rest of the Fed leaders (Big Buyer No. 1) have clearly signaled their intentions to wrap up QE2 in June. And Kelly says individual investors (Big Buyer No. 2), who plowed money into bonds after the financial crisis, have also begun moving money back to stocks. Generally, he sees that as a good trend. But he cautions investors against taking that too far. "You need some exposure to bonds" for diversification, he says. "They will be defensive if the weather turns nasty."
Of course, that might be cold comfort if rates shoot higher in the short term, which would be a painful process for investors who own a big chunk of bonds. "Bondholders have had a great time the last 30 years," as bond prices marched steadily higher, says Gross. "But eventually you have to pay the piper." Even then, there'd be one winner: American savers, who could finally get a return that isn't microscopic from a savings account or a money market fund.