Published June 2, 2017
We are now a decade into the Federal Reserve’s latest period of monetary policy seeking to stimulate the economy. Prior periods of monetary policy focused on pushing very short-term interest rates higher or lower to accelerate or decelerate the economy and/or inflation. The unprecedented impacts of the financial crisis forced the Fed to adopt additional monetary policy tools, such as “quantitative easing” or “QE” for short. QE allowed the Fed to expand their participation in financial markets through purchases of longer-range bonds as well as other, non-Government bonds – primarily mortgage bonds. Through these tools, the Fed was hoping to impact interest rates more broadly during this very unsettled period.
A key complimentary piece to the Fed’s strategy for rebuilding investor confidence was to become more open and proactive in their communication. While some derided this “talking up the markets”, there’s no question that investors received extraordinary guidance from the Fed as to the timing and pace of their plans for interest rates, such as they knew them.
Chart 1 below shows the history of short-term, 1-year, interest rates. The blue arrows are periods of declining rates where the Fed is rapidly lowering the “cost” of money in order to stimulate the economy. The red lines are periods of rising interest rates where the Fed is seeking to slow the economy down. You can see the sharp rise in interest rates prior to the financial crisis, while the recent rise has a much more gradual slope to it as the Fed goes slower.
Chart 1: 1-year U.S. Treasury rates
The tools by and large worked to restore a frightened investment community to return to taking risk in the markets. Stocks hitting new highs recently and the extremely low volatility surrounding the stock market over recent years is a direct result of the Fed’s actions. While some may argue that stock markets have overshot their true value, that’s merely a function of the investing process. Stocks always go too low and too high around their “true” value. Finance and investing are largely built on confidence. Rebuilding that confidence is at the core of what the Fed’s been trying to achieve since the crisis. Record highs in the stock market (along with elevated price-earnings ratios) seem, to us, a reasonable indicator of that success.
With the interest rate ramp pretty well understood by investors, the Fed has shifted the focus of its communication to its balance sheet. As the Fed bought bonds of almost all kinds seeking to shore up the bond market and keep interest rates low, those bonds took up residence on the Fed’s balance sheet as an asset. That balance sheet has ballooned to over $4 Trillion from well under $1T prior to the financial crisis. The Fed’s stated goal is to begin reducing that balance sheet in a long-term effort to return to a more normal state. Initially, the Fed simply halted the growth in its balance sheet, using only proceeds from bonds that matured to buy new bonds. Now, the Fed will slow down the reinvestment of those proceeds, letting the bonds mature without putting the received cash back into the market. This will reduce the Fed’s balance sheet of bonds and can be modulated to be faster or slower as the Fed chooses.
To summarize, the Fed attempted to shore up markets and stimulate the economy by first lowering interest rates then by actively buying bonds of all kinds in the open market. Now, with the economy humming along on more solid footing, the Fed has begun raising interest rates and is on the verge of stopping its participation in the broader bond market. It’s a complicated and delicate dance accompanied by lots of communication with the investment public. All in hopes of restoring confidence in both markets and the economy. The job is never fully done as a new financial crisis occurs, on average, every decade. With a broader palette and toolkit from which to work, it is hoped the Fed can limit the damage from future attacks of fear in the markets and smooth out economic fluctuations.
Investors returned from the Memorial Day holiday with little action in Tuesday’s essentially flat session. Nor also in Wednesday’s flat trade. Wednesday did have a tumble in oil prices as investors continue to question whether the OPEC production cuts will be adhered to. The month of June kicked off Thursday in strong fashion with the lagging small cap stocks vaulting +1.9% on a broadly strong day for stocks. There was little obvious news behind the move other than the turn of the calendar. The bullish fervor carried over into Friday despite a weaker than expected monthly employment report. Stock investors, reflecting their bullish bent, ultimately viewed the report as meaning that interest rate hikes would be less of a concern going forward. The 10-year U.S. Treasury rate fell under 2.2% on the report. Strong earnings from chip maker Broadcom (AVGO) continued a parade of solid tech earnings to keep the tech-heavy Nasdaq powering upward.
For the week, the S&P 500 (SPY) added another +1.02% to close the week at record high level. The Nasdaq 100 (QQQ) tossed +1.59% on its market-leading 2017 performance. Small-caps (IWM) finally joined the party with a +1.68% rise.
Warm wishes and until next week.