Goldman Sachs Group, Inc. (GS), Morgan Stanley (MS), How To Win in an Environment of Rising Interest Rates

What is the best way to react to the Fed’s policy tightening measures? This is a question that should be on the mind of every investor as bond yields are continuing to climb.

Ben Bernanke at the Joint Economic Committee

Ben Bernanke basically caused a market sell-off in the bond market. As the world’s most powerful banker stated that he would be willing to raise the federal funds target rate once the unemployment rate were to hit 6.5%. The problem is that the unemployment rate is currently 7.5%, and a full 1% decline in unemployment could happen within the next year and a half. But it may take less time than that.

In response to a rising interest rate environment, bond investors have sold their bonds aggressively onto the bond market. This should be a point of concern to investors as declining bond values will hurt every investor’s portfolio.

Source: Ycharts

The value of the iShares Barclays TIPS Bond Fund (ETF) (NYSEARCA:TIP) has declined by 3.87%. This hurts fixed income investors as rising interest rates means that the value of a bond note will decline in response. Investors are now investing aggressively into stocks.

Source: Ycharts

The SPDR S&P 500 (NYSEMKT: SPY) gained 13% since the beginning of the year. These gains are likely to continue in an environment where bond values are declining and stock values are increasing. After all, if you had the choice between making money and losing money, chances are you will choose the option that would help you to make the most money.

Legal power of banks

The Financial Accounting Standards Board has made some changes in 2009 that allow for mark-to-market accounting practices. This means that a company will have to record paper gains or losses without actually realizing them. So if a bank had a position in a stock, and the value of the stock declined, the company would have to report that decline in value as a loss immediately (even though the bank hasn’t sold the stock yet).

This has huge implications in the bond market. If the value of a bond decreases, the decrease in the value of the bond would be fully reflected in the bank’s financial performance when it reports earnings. Larger banks, as a result, have been buying stocks; this will result in an increase in the amount of earnings a bank can report to shareholders.