It is assumed the “great rotation” causes money to flow from bonds to equities that drives the stock market higher. However, in the present context, many disagree saying it’s simply new cash that’s driving the markets higher.
Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock Inc, is one who agrees with that theory. If you look at the data, you’ll see that what happened last year when we had the fiscal cliff concern, people were afraid and we saw a growth in deposits and money market funds. First two months of the year, that money came out of bank deposits and money market funds and went into the stock markets. However, it’s not the great rotation yet, but the”other great rotation” where hard cash has flown into equities, noted Jeff.
Asked what yields are required to drive people to equities from bonds, Jeff said you need to see significant and protracted losses in the bond market to witness the “great rotation,” i.e. yields of above 3 percent for 10-year Treasury notes; current yields are nowhere near that now, he said, adding the US witnessed 30 years of declining interest rates and it will take more than one month to convince people to take their money out of their bond portfolios.
What happened in 2008 has fundamentally altered investors’ risk tolerance. When you put that on top of demographics, retirees and those getting close to retirement, there’s not the same degree of desire for equity holdings as there was when the demographics were much younger. The great rotation may be a rotation on the margin since a large number of people are going to stay invested in bonds regardless, he argued.
Asked if sees the high-yield/junk bond market heating up and bubbles forming, Jeff said the problem with Fed policy is that with interest rates at 2 percent for 10 years, they are below the level of inflation. So, when people talk about “reaching for yield,” they don’t really reach for yield. They are reaching to get a yield that is above the level of inflation to protect their savings. When interest rates are set by the Fed to be so low for so long, then it blows up, he noted.
Asked if Fed Chairman Ben Bernanke needs to change gears to ensure investors actually make money in the bond markets, Jeff said Bernanke and the Fed talk about unemployment and how to get the economy growing. But savers don’t simply sit back and accept negative real returns. They take action – they take on greater risk. And that’s one of the problems in that when it’s not addressed in the form of raising interest rates from the policymakers, then what you get is the potential for asset inflation bleeding into asset bubbles. That’s where the longer run consequences come in.
Asked how much the economy needs to improve before the Fed resets its monetary policy, Jeff said the accommodative monetary policy will stay in place until the economy is well into a recovery.
The question in everybody’s mind though is when is the Fed going to withdraw and how can it manage it without disrupting the financial markets. It’s very difficult for the Fed to exit a policy without some financial market volatility. The VIX index has dropped to 11 because we are pricing in the benefits of the Fed’s accommodative policy.
QE is working now, and as we’ve seen, higher wealth is leading to greater spending due to the wealth effect, and there’s a draw-down in savings. The problem is about getting out without undermining the stability of financial markets.
You can watch the video here.
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