Understanding what the Federal Reserve said….and didn’t say
Based upon the outtakes of the two days of Federal Reserve meetings last week and the press conference with Federal Reserve Chairman Ben Bernanke that followed….
Here is what the Federal Reserve did tell the markets:
- They may begin to pull back on the reins of their stimulus programs, by tapering their bond purchases, if the economy continues to improve through the end of 2013.
- They will not begin to taper their monthly bond purchase/stimulus of approximately $85 billion/month yet but may start in the Fall of 2013 if warranted by the state of the U.S. economy at that point in time.
- They remain, willing and ready, to decrease or increase the amount of their monthly bond purchases as necessary.
- The Federal Reserve may end the bond purchase program, in its entirety, by the middle of 2014.
- Economic activity continues to expand at a moderate pace.
Here is what the Federal Reserve did not tell the markets:
- They are not increasing interest rates. In fact, they are taking no action on interest rates at this time and decided to keep the federal funds target rate at 0.00% – 0.25%.
- They are not making changes to their earlier stated forecast of keeping interest rates at these record lows until, at least, the middle of 2015, with the exception that they may look to take action on interest rates sooner if consistent economic growth continues, their unemployment rate targets are hit and inflation remains within their comfort range. To paraphrase, they intend to keep rates at record lows:
“…as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
Source: Federal Reserve Bank Press Release, June 19, 2013.
As a point of reference, the Federal Reserve currently believes that unemployment will decrease to 6.65% in 2014 and that economic growth, as measured by Gross Domestic Product (GDP), will be within a range of 3.0%-3.5% in 2014.
It would seem that what the Fed said, and didn’t say, would be received positively by:
a) Investors looking for signs of a firming economic foundation to support additional market growth; and
b) Investors concerned with how, and when, the Fed will start to scale back on their enormous stimulus program.
To the contrary, investors fled the markets altogether following last week’s Fed meeting, and press release, with bonds and equities (and most other major asset classes) falling significantly. The following representative listing of index returns over the time period of June 19, 2013 – June 21, 2013 will help demonstrate the extent of the immediate fallout in the markets.
Total Return %
|S&P 500 Index1|
|MSCI World ex U.S. Index2|
|MSCI Emerging Markets Index3|
|DOW UBS Commodity Index4|
|Bloomberg U.S. Treasury Bond Index5|
|Barclays Aggregate Bond Index6|
|S&P Municipal Bond Index7|
Source: Bloomberg, June 26, 2013. Past performance is not an indication of future results. You cannot invest directly in an index.
1S&P 500 Index – Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
2MSCI World ex U.S. Index – The MSCI World ex U.S.A Index captures large and mid-cap representation across 23 of 24 Developed Markets DM countries*–excluding the United States. With 1,002 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country
3MSCI Emerging Markets Index – The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
4DOW UBS Commodity Index – The DJ-UBSCI is composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange (LME). Trading hours for the U.S. commodity exchanges are between 8:00 AM and 3:00 PM ET. A daily settlement price for the index is published at approximately 5:00 PM ET.
5Bloomberg U.S. Treasury Bond Index – The Bloomberg U.S. Treasury Bond Index is a rules-based, market-value weighted index engineered to measure public obligations of the U.S. Treasury which have a maturity greater than 12 months. To be included in the index a security must have a minimum par amount of 1,000MM.
6Barclays Aggregate Bond Index – The Barclays U.S. Aggregate Index represents the securities of the U.S. dollar-denominated, investment grade bond market. The Index provides a measure of the performance of the U.S. dollar-denominated, investment grade bond market, which includes investment grade (must be Baa3/ BBB-or higher using the middle rating of Moody’s Investor Service, Inc., Standard & Poor’s, and Fitch Rating) government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly offered for sale in the United States.
7S&P Municipal Bond Index – Tracking over U.S.D 1.3 trillion in municipal debt, the S&P Municipal Bond Index1 is a broad, comprehensive, market value-weighted index following approximately 59,000 individual bond issues that are exempt from U.S. federal income taxes or subject to the alternative minimum tax (AMT). The S&P Municipal Bond Index has been tracking the municipal bond market since December 2002.
I contend that the mass selling that followed the recent comments from the Fed was an overreaction by many investors and while it is prudent to start bracing certain growth-oriented portfolio strategies for an environment of rising interest rates, we welcome the forward looking optimism of the Fed with respect to the U.S. economy and their transparent plan to look to start tapering their bond buying on a measured basis. I also believe that while the Fed may scale back on their bond purchase program within the next year, the likelihood of the Fed raising interest rates within the next year is minimal given the current pace of GDP annualized growth, muted inflationary pressures and relatively weak hiring patterns on the part of the private sector.
Adding more credence to this sentiment, 1st quarter 2013 GDP was revised downward to just 1.8% this morning. As a result, GDP would need to grow over 60% (from 1.8% to 3.0%) on a relative basis to reach the target set by the Fed in this regard. If this dramatic rate of growth were to occur, and the other previously discussed Fed targets were also hit, it is fair to assume that, at that point, the Fed is likely to raise short term interest rates and/or begin to reduce the size of their bloated balance sheet – which currently stands at over $3 trillion (see the chart below) – through the outright sale of bonds as opposed to just reducing the amount of bonds that they purchase each month. In that type of environment, while bond prices (i.e. lower) and yields (i.e. higher) might be affected, the common stock of companies partaking in the growing U.S. economy would certainly stand to benefit.
Federal Reserve Balance Sheet – Pre and Post 2008 Crisis
Total Balance Sheet, Jan. 2007: $859 billion
Currency: $820 billion
Reserves: $12 billion
T bills: $277 billion
T bonds: $502 billion
Total Balance Sheet, March 2013: $3,084 billion
Currency: $1,173 billion
Reserves: $1,748 billion
T Bills: $0
T Bonds: $1,756 billion
Mortgage-Backed Securities: $1,015 billion
Agency Debt: $74 billion
Source: NewMonetarism, “The Balance Sheet and the Fed’s Future”, March 10, 2013.
Until that point in time, we, at Hennion & Walsh, believe that growth-oriented investors would be wise to revisit their portfolio strategies to help ensure that they have the diversification in place to withstand future periods of intermittent market volatility this year resulting from uncertainty over when, and how, the Federal Reserve will take action, while also preparing for gradually increasing interest rates.
We would also remind income-oriented investors that rising interest rates do not impact the interest that they receive on their bond holdings nor do they change the ability of these investors to receive par value on their bond holdings at maturity. Bond fund investors, on the other hand, may see the interest they receive on their fund holdings change in a rising rate environment and will not receive par value at maturity as there generally is no set maturity on bond funds.
Please note: This is for information purposes only and is not solicitation to buy or sell any of the security types mentioned.