Fed Policy Still Driving Markets

The US economy continues to plow persistently ahead despite the strong headwinds of high unemployment and restrictive fiscal (government spending) policy. The economy added 195,000 jobs in June and has added an average of more than 200,000 each month this year. But the improvement in jobs, while steady, is not so robust that the Fed is going to soon reduce its generous stimulus measures of quantitative easing (QE3) or very low interest rates.

This past Wednesday, Fed Chairman Ben Bernanke set investors straight by saying “You can only conclude that highly accommodative monetary policy for the foreseeable future is what’s needed in the U.S. economy.” Markets, particularly bond markets, had over-reacted to Mr. Bernanke’s June 19th remarks, believing the Fed was going to remove stimulus faster than they intended.

The bond-buying program know as QE3 is designed to drive down borrowing costs and push up asset prices to encourage an increase in investment, spending and hiring in the broader economy. If the economy doesn’t continue to improve, Fed officials have said they would hold off on further reductions in bond purchases or even increase them if required by economic data.

The Fed has set two targets for unemployment to provide investors with some understanding as to when they will begin cutting back their stimulus measures. The first is 7% unemployment. If the economy proceeds as the Fed expects, 7% is where the jobless rate will be when they end their bond-buying program and the economy will have enough momentum to grow without the boost provided by the bond-buying program.

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The next unemployment target is 6.5%. The Fed has said it won’t start raising short-term interest rates until unemployment is at least this low. But the markets don’t believe the Fed. Investors have linked the two programs believing that an early exit from QE3 implies an earlier than 2015 exit from low rates.

But Fed officials and the minutes released this week strongly refute these beliefs. What’s more, comments from officials have reminded investors that even hitting the 6.5% threshold doesn’t mean they would automatically raise interest rates and that they expect interest rates to remain near zero for a long time after they end the bond program.

Investor over-reaction was not more evident than in the US Treasury market. The 10-year US Treasury rose from a yield of 2.18% on Bernanke’s June 19th announcement to peak at 2.72% this past Monday before falling to 2.57% yesterday on Bernanke’s calming comments and Fed minutes yesterday.

There has been another sign of persistence lately that has probably gone unnoticed with all the attention focused on stocks’ new highs.

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The chart above represents the price movements of our 7-10 Year US Treasury ETF (symbol IEF). The large red bar indicating a 1.4% decline under the #2 occurred on June 19th when Mr. Bernanke was interpreted as ending the QE3 much faster than he intended. Note, however, the resilience and persistent strength exhibited after each knockdown. Each rally upward represents more than 1% gains. A strong case can be made that the premium form QE3 is now gone from the IEF.

Stock investors were also encouraged by Bernanke’s comments yesterday as they drove the S&P 500 up 1.4% yesterday to a record 1,675.02. The index is up 2.6% in the past five days, and is headed for a third straight week of gains. It is up 6.4% since its June 24th low and our Vanguard Total US Market ETF is up just under 7% during the same period.

As we enter the beginning of the second quarter earnings season, we’ll hopefully see corporate and economic fundamentals regain primacy in market movements, replacing Fed and its policies which have dominated market movements for months now.

Today we learned that consumer confidence improved in June and that inflation sparked 0.8% at the wholesale price level, driven primarily by energy costs and automobiles. It was the biggest jump since September 2012.

The Central Bank has made it clear that our economy is not yet strong enough to stand on its own. They have emphasized that they do not expect to remove accommodation entirely for another couple of years. But, they do expect to end QE3, the massive Treasury buying program, within the next 12 months and with it the unusual impact on Treasury prices.

Investors, particularly bond investors project well into the future the latest information and trends to assign value. It is entirely reasonable to assume that Treasuries already fully represent (barring economic calamity) in their prices the end of QE3 and its unusual dynamics inflicted on the asset’s price behavior.  Treasuries will soon resume their traditional trading patterns.

Have a great weekend.

Author Sam Bass Jr.

Sam founded Beacon Wealthcare in 1998. He has thirty five years' experience investing money for his clients. In 2006 he changed the focus of his firm from asset/return to a client/goal-centered and adopted state-of-the-art planning and management systems to deliver the best fully integrated planning service available. Sam holds a BA in English Literature from Hampden-Sydney College, 1975 and an MBA from Wake Forest University, 1981. He concentrated in International Finance, and did research for an International Finance textbook which included a summer at the London School of Economics. He is married to Sharon, a talented pleinAir oil painter, They enjoy being with their three children, their spouses, and five beautiful grandchildren as often as they can. Sam loves Jesus, sailing, cycling, and writing.

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