During various periods of time throughout history, financial markets have often been driven by one major swing factor which can usually be boiled down to a particular word or phrase. Over the past few years the pivotal buzzword has been Quantitative Easing or “QE”. The very mention of the two letters “QE” in the press, or any its various iterations were sure to send markets flying in either direction. Essentially, QE has been the central bank’s way of playing its full hand. In an attempt to resurrect the US economy from the aftershocks of the Great Recession, the Fed created QE1, 2 and 3. On the back of these aggressive stimulus measures the S&P 500 stock market index soared 146% from its bottom in March of 2009 to a recent new high in May while bond yields fell to record lows.Lately, the new buzz word is “tapering” which, in fact, is the very opposite of QE in that it refers to the unwinding of QE or a reversal of monetary stimulus. Since May, America’s Federal Reserve bank has been telegraphing the idea that it may soon begin winding down or ‘tapering’ off its massive monetary stimulus programme which is presently designed to buy $85 billion in bonds and mortgages each month in the open market in an effort to keep interest rates low and stoke economic growth.What goes up often comes down and since May 22nd when Bernanke first made comments about tapering, the S&P 500 stock index has fallen about 5% while longer term interest rates, as measured by the benchmark ten-year Treasury bond yield, have risen from 1.6% to 2.5%, marking a 22 month high at the beginning of this week. A week ago, both stock and bond markets plunged rather dramatically following Bernanke’s latest comments suggesting the central bank may start reducing bond purchases later this year and possibly end them in the middle of 2014.Bernanke indicated that the Fed would maintain the $85 billion pace of monthly asset purchases for the time being and that it sees the “downside risks to the outlook for the economy and the labor market as having diminished since the fall.” However, the Federal Open Market Committee (FOMC) repeated that it is prepared to increase or reduce the pace of purchases depending on the outlook for the job market and inflation. After parsing the speech, most economists are now anticipating that the Fed will reduce its monthly bond purchases from by about $20 billion to $65 billion per month starting this September.Tapering Versus RaisingTaking a closer look at the Fed Chairman’s speech, however, these comments are not entirely negative. First of all, the Fed left unchanged its statement that it plans to hold its target interest rates near zero as long as unemployment remains above 6.5% and the outlook for inflation doesn’t exceed 2.5%. Presently, the unemployment rate stands at 7.6% and inflation about 1.4% as measured by the consumer price index (CPI). These relatively benign data points allow the Fed plenty of leeway to continue buying bonds, at least for right now.While the Fed is standing pat at the moment, the recent back up in longer term interest rates indicates that investors expect the Fed will begin raising short term interest rates (the rates the central bank can directly control), perhaps aggressively. This potential scheme of rapidly rising interest rates has been compared to the scenario which played out in 1994. At that time, the Fed began a series of steady, incremental rate hikes totalling up to a 3% rate increase aimed at cooling down what was then perceived as an overheating economy.However, in this case bond markets may have overreacted. The Fed is indicating an easing of bond purchases in the open market rather than actually raising interest rates and appears to be targeting the middle of 2014 as the time when it will stop buying securities in the open market. Until that time, the Fed is likely to remain on hold with short term interest rates near zero. Furthermore, the comparison to a 1994 scenario is not quite fair. During that time the US was growing at a rate of over 4%. In contrast, just this week, the Commerce Department reported that America’s gross domestic product (GDP) grew only 1.8% in the first quarter, less than half of the prevailing rate nineteen years ago.Realistically, the Fed first has to decide if and when the American economy is strong enough to begin withdrawing stimulus. And then, only after the decision to end QE, will the Fed begin to think about sending interest rates higher. Moreover, decisions about tapering monetary policy and increasing interest rates are highly data dependent. Any additional shocks to the global financial system such as what we have seen in recent months from Greece, Spain and Cyprus or any backsliding in the US economy could cause the Fed to change its tack.Riding Down the Yield CurveOne benefit of the selloff in longer term bonds while short term rates are pinned near zero is that the yield curve has become steeper. This means that fixed income investments will “ride down the yield curve” to a great degree as individual bonds approach maturity.For example, in one year’s time, a three-year bond becomes a two year bond which will then be better bid if rates stay where they are presently. If the current term structure of interest rates persists, the three year bond will become more valuable as it becomes shorter in maturity because shorter term interest rates are lower than longer term interest rates along the steep curve. Improving bids on bonds riding down the curve has the potential to add value a bond portfolio in addition to the income generated from the regular coupon interest.Another factor making the bond market more intriguing has been a widening of credit spreads. Spreads on many corporate and sovereign bonds have fallen in price, i.e. increased in yield, at a faster rate than comparable government bonds of the same maturity. Interestingly, widening credit spreads traditionally occur as a result of concern about an economic downturn rather than the more optimistic predictions we have heard from the Fed lately.Opportunities in Dividend Paying StocksIn addition to opportunities for riding the yield curve and taking advantage of higher credit spreads, equities markets also may be offering attractive gain potential for longer term investors. Atypically, higher yielding stocks have been pummeled as much or more than the overall market in recent weeks. The intense selling that has occurred in interest sensitive sectors such as banks, real estate investment trusts (REIT’s) and utilities is reminiscent of 2012’s year-end correction caused by America’s fiscal cliff negotiations. Investors who bought high quality, dividend-paying equities at that time were amply rewarded over the ensuing months.Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.