At the expense of emerging markets, capital is finally returning to the United States. For example, a number of emerging market currencies have been steadily depreciating against the dollar. Why have investors decided to return to U.S. assets? Because the U.S. is showing signs that the recovery is gaining traction. Data released on Thursday 1/30/14 showed that fourth quarter gross domestic product grew at a seasonally adjusted rate of 3.2%. According to the Wall Street Journal, “A big driver of growth in the fourth quarter was a rise in consumer spending, which grew at 3.3%, the fastest pace in three years. Consumer spending accounts for roughly two-thirds of economic activity”. Consumer spending is an indispensible component of economic growth. I think increased business investment is likely to follow this strong consumer spending. With healthy amounts of business investment and consumer spending, future prospects for the U.S. economy look extremely bright for the first time in awhile! The Fed’s decision on Wednesday 1/29/14 to continue the taper was primarily based on the strengthening U.S. economy (it is also partially due to the fact that the Fed does not like using quantitative easing).
As the U.S. continues to strengthen and attract capital, where are investors putting their capital – the stock market or the bond market? The answer is the bond market, which is evidenced by climbing 10-year Treasury prices and falling yields (recall that prices and yields move in opposite directions). The decision of investors to enter the bond market represents a flight to quality. Government bonds are a risk free investment (the downgrade does not concern me at all). Despite the evidence of a U.S. economic recovery, investors still prefer to invest in the bond market. According to the Wall Street Journal, “Much of the surprise can be attributed to the sudden turmoil in emerging markets and worries about a slowdown in China’s economic growth, which have driven investors to investments perceived as safer, notably government bonds”. Struggling emerging markets and China’s slowdown understandably create concern for investors, which contribute to their decision to buy bonds over stocks. First, falling international markets can hurt U.S. portfolios with exposure to slowing growth in emerging markets as well as China. This could then hurt consumer discretionary spending. Second, coordinated growth would be much healthier for the global economy than one where some countries take from others. Although investors in developed countries might be pleased to see economic improvement in the U.S, the risks of contagion from emerging markets and globally induced deflationary pressures are valid reasons for concern.
Nonetheless, the flight to quality comes as a surprise. I, for one, expected yields to rise as the Fed tapered. Tapering means decreasing Fed demand for bonds and falling demand causes prices to fall and yields to rise. Moreover, the fall in yields goes against the intentions of the Fed’s decision to taper. As the U.S. economy improves, the Fed wants yields to begin rising. Quantitative easing was initially implemented to lower long-term interest rates. Now, the Fed intends to let interest rates slowly increase through tapering.
In any case, I do not think rates are going to continue going lower indefinitely. The flight to quality only makes sense as long as investors are worried about something. According to the Wall Street Journal, “Some investors and strategists said they believe rates will end the year higher, but agree there may be room in the interim for them to dip lower than previously thought”. I agree and think that we will ultimately see rates rise, however, I am not sure when.