Bernanke’s brakes on bonds good for stocks

Kathleen Brooks
THE snow forced Federal Reserve chairman Ben Bernanke to submit a written testimony to Washington’s legislators yesterday rather than go to Capital Hill in person, but the message the Fed governor delivered was the same regardless of the weather: he plans to withdraw support from the financial markets at some point soon.

Bernanke outlined a blueprint on Wednesday for how the Fed will reverse its accommodative policy at the “appropriate time” for the US economy.

The asset purchase programmes implemented by the Fed in the aftermath of the financial crisis have helped to keep a cap on government bond yields for the last 18 months. But if credit easing in the US is on its way out, the pressure to keep yields low is likely to wane. “The only way for yields are up,” says Mark Oswald, strategist at Monument Securities. This is bad news for bonds, since as yields rise their prices fall.

Liquidity withdrawal is not the only thing weighing on bonds. The budget deficit, currently estimated at $1.3 trillion for this year, is also a threat. If the US government does not take steps to bring the shortfall under control then credit rating agency Moody’s has said that the US triple A rating could be in jeopardy. In that situation investors will start to demand higher yields to hold US government debt, putting more pressure on the price.

While the risks surrounding the outlook for US government debt continue to mount, equities look fairly stable. Credit spreads on corporate debt have fallen and balance sheets for US blue-chip companies are at their strongest since the onset of the financial crisis. The S&P 500 has fallen 6 per cent since the start of the year, but the recent pull back offers some good opportunities for investors.

The outlook for US economic growth is fairly tepid for this year but stocks remain preferable to bonds as large cap US companies with exposure to faster growing overseas markets should continue to perform strongly.

For example, Coca Cola announced strong results on Tuesday driven by sales growth in emerging markets.

The easiest way to get broad-based exposure to corporate America is to buy the S&P index. Using covered warrants is one of the cheaper ways to do this, because you only pay a fraction of the cost for a covered warrant whereas if you bought all 500 stocks your initial costs would be much higher.

But it’s worth remembering that the overall outlook remains fragile and covered warrants are a good way to reduce your downside risk since the maximum you can lose is your initial capital.

Timing is key for this trade and buying a covered warrant with a relatively short life is key. RBS has a call covered warrant with an expiry date on 17 June and a strike price of 1,100. If you want to make the call even cheaper, especially if you are particularly upbeat about the outlook for the S&P, then you could choose a strike price of 1,200 with the same expiry date. Alternatively Societe Generale has a call that expires on 18 June with a strike price 1,300.

Bernanke might be stuck in the snow, but the financial markets continue to plough on.