Does the Fed control the markets?

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)

 

I think it’s more fair to say, depending on the when and at what pace the Fed decides to limit or stop bond buying, that it could certainly increase volatility and turn out to be many things to an investor’s portfolio. I think it’s also important to note that the ongoing buying of bonds may continue to push or keep interest rates low, which may continue to force investors to do one or both of two things: 

  1. Chase yield. This is when investors — who once were getting, for example, 3%-5% CD yields and are now getting 0%-2% yields — choose to chase the same 3%-5% yields but in riskier investments. 
  2. Chase stocks. In a similar vein, they may buy stocks under the premise that stock returns theoretically should exceed bond returns. (Note: That’s not always the case.)

Either way, people who chase returns and yield will continue to take on greater risk for similar return. Investors who aren’t considering this may be in for a rude surprise (assuming they weren’t already surprised this past summer) if the risk is experienced again. 

Remember that, ultimately, higher returns are only achieved when the risk doesn’t materialize. The tradeoff of not chasing yield or returns and parking cash is that if the risk described above is never realized, you will have certainly lost out on a much better return. Of course, if the risk is realized, you will be glad to have been more conservative in your perspective. I don’t think anyone has a clue what the future will be, so the focus today is on blending the reality of a policymaker marketplace with core principles of investment management.

I don’t really like government policy influencing capital markets, but we play the hand we’re dealt, not the one we want. The Fed is a formidable market player, and like it or not, it is influencing market pricing. If and when the Fed decides to stop buying bonds, the stock and bond markets will respond in some fashion. It may not be the worst-case scenario many pundits are envisioning, but investors should be conscious of various possibilities, including positive ones, and prepare their portfolios and expectations for many possible outcomes.

Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is also an adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.

 This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s. Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio's performance are based on historical data and one should not assume that this performance will continue in the future.
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