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Sep 25, 201307:42 AMFinancial Perspectives

with Michael Dubis, CFP

Does the Fed control the markets?

(page 1 of 2)

It feels like it, doesn’t it? 

For a few years now, the stock market has been on a tear and bond market yields have dropped significantly (at the same time, bond values have risen). Many would argue that a large contributor to that run-up has been the Fed’s quantitative easing/bond-buying policies. 

I think that’s a fair argument. The Fed has been buying about $85 billion worth of government bonds every month. To put that in perspective, the U.S. deficit was approximately $1.1 trillion in 2012 and is projected to be about $670 billion to $970 billion in 2013 (depending on the source and projections). In other words, the Fed has essentially (directly and indirectly) been funding our annual deficit. It is an understatement of a lifetime to say that the Fed is a major participant in the pricing of stock and bond markets. 

The Fed’s impact on the stock and bond markets has been apparent in the past few months and was again last week. In May and June, we saw the stock markets and especially the bond markets react rather negatively when the Fed announced that it would begin slowing its bond buying, which resulted in a huge run-up in interest rates (and in bond values dropping). And then just last week, the Fed “surprised” the market by saying it will not be slowing its bond buying. Shortly thereafter, bond yields dropped, bond values rose, and so did, to some extent, the stock markets. In other words, the markets have been highly correlated to the Fed policy on buying bonds. 

This is very important to consider in your investment planning. We’re not in Kansas anymore, where we can assess risk-return tradeoffs solely on core investment and economic fundamentals, while risk-free bonds like CDs and Treasuries offer almost no lifestyle yield for most retirees. (Perhaps we never were in Kansas, but that’s for another time.) Today, the policymakers are major players in capital markets and are significantly influencing market behavior. This is confusing. The Fed seems confused as well. This creates ambiguity, which then creates volatility and uncertainty.

It’s clear, though, that the Fed has some, if not a large, influence on market pricing, and it’s clear that at some point in the future, the Fed will have to stop or at least slow the bond-buying process. Unfortunately, what all this means to markets over time is debatable. Many writers and talking heads scream that it will eventually lead to chaos. I don’t know if it’s that clear. If it were, the market — today — would be in a free-fall in order to price in that chaos. But it’s not. In fact, it’s somewhat positively priced. I believe that’s because, as I write this, most informed investors know everything I’m saying and then some, and so you see that the markets can and will price in risk rather efficiently. It doesn’t mean the risk has gone away, though. It just means there are very different opinions about the future, and money is being invested to weigh those opinions. 

(Continued)

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About This Blog

It is an understatement to say the world has experienced a radical shift in capital markets. There are more layers of information and opinions on the direction of the world than we've seen in decades. The internet and the media do not always make it easier, but Michael Dubis' contribution through IB blogs will help you sift through the noise and give you some perspective. You can find his company online.

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