Markets Labor Under Fed Policy Contradictions

As mentioned in last week’s column, the entire dynamic of financial markets changed after the May 22 Congressional testimony of Fed Chairman Bernanke and the release of the minutes of the last F.O.M.C. meeting. During his prepared testimony and subsequent answers to the House panel, he made contradictory statements as to the extent and duration of the current stimulus package, which consists of $85 billion a month in purchases of both long-term Treasury bonds and mortgage-backed securities.

Adding to the confusion for investors are the almost daily statements regarding this issue from various Federal Reserve officials expressing their views on the matter and their reasoning behind those views, and to read their comments one would think that they are looking at two different economies, rather than the current state of the U.S. recovery. These almost daily contradictions have further intensified the confusion. In fact, one observer mentioned that the market is looking at each piece of data through “Fed sunglasses,” meaning that it is not what the data itself says, but rather what an investor believes the Fed thinks about the particular piece of data.

And this sort of confusion is why in the course of three days last week, on Wednesday the major averages made their second largest decline of the year while on Friday they produced their second-best advance of 2013, which meant that there were two huge contradictory moves in the course of those three days, an almost unprecedented event.

Friday’s explosive upside rally, courtesy of the May jobs report which came in slightly above consensus, allowed the major equity indexes to escape the ignominy of declining for three straight weeks, after they had already declined for two straight weeks for the first time this year. On the other hand, one market that has now declined for six straight weeks is the bond market. And the damage has been considerable as mutual funds that invest in long-term U.S. Treasury bonds lost an average 6.8 percent in May, as the loss of principal wiped out years of interest payments. Even worse than that have been higher-yielding bonds, especially mortgage-backed securities and emerging market debt, in addition to instruments in this area that use borrowed leverage in an attempt to increase returns. And bondholders can thank Chairman Bernanke for their losses, as in an answer to a question he said that “we could in the next few meetings take a step down in our pace of purchases” after saying in his prepared testimony that there was no indication that Fed policy would change so soon.

High dividend stocks, often purchased as investors look for steady income when rates in the bond market are as low as they have been, have also taken a tremendous beating lately. These would include utility stocks that have fallen more than 10 percent on average, in addition to telecommunications issues as well.

If investors are confused by what the Fed is really thinking, they certainly have a right to be, as there is little precedent for what kind of effect withdrawing some of the current record level of stimulus would have on the markets. If the economy is indeed doing better, then paring back the stimulus could be beneficial, while on the other hand it could cause disarray considering the extent to which investors have come to rely on these Fed bond-buying programs since the depths of the financial crisis almost five years ago.

This has led to significant disagreement among investors about whether the economy will improve enough for the Fed to start this unwinding process as for instance last Friday’s jobs report which showed gains of 175,000 positions was interpreted as a sign that the economy is indeed growing fast enough to allow for some kind of withdrawal between the September and December Fed meetings. On the other hand, Mr. Bernanke himself has said that the Fed would keep its foot on the pedal until the unemployment rate declined to 6.5 percent. It was 7.6 percent as of Friday’s jobs report, which is another example of the contradictions that are really confusing investors at the present time.

Then there is the possibility that if interest rates continue to rise — as they certainly have been doing, with the 30-year bond reaching its highest level since March 2012 at a 3.37 percent rate while the 10-year note, upon which most mortgages are based, rose to its highest level this year on Monday at 2.22 percent — it would become more difficult for prospective homeowners to take out a mortgage. This could derail what has been one of the major sources of economic growth over the past few years, namely, the recovery in the housing market.

Also helping interest rates increase to their highest levels of the year was Monday’s decision by the Standard & Poor’s rating agency to revise its credit outlook on the United States government to stable from negative, pointing out Congress’s avoidance of the end-of-the-year “fiscal cliff” drama (remember that one?) and the higher-than-expected tax receipts that followed. And investors can recall when their first-ever downgrade of our government’s debt in August 2011 resulted in unprecedented turmoil in the stock market and interest rates eventually declining to their all-time low levels since then.

They also said that they do not expect the debate later this year regarding raising the debt ceiling to result in “a sudden unplanned contraction in current spending, which could be disruptive.” S&P pointed out that recent increases in tax receipts and steps taken to address longer-term budget issues had improved the U.S. outlook. At the same time, they did raise concerns about the ability of policymakers to tackle long-standing issues due to a deepening of the partisan divide in Washington, D.C. during the last decade.

Of course, S&P should not have downgraded our debt in the first place to begin with because if a credit rating is supposed to predict the probability of a default it is certainly nonsensical to give the U.S. government anything but the highest rating, which is AAA. This was taken down to the current AA-plus level. At the same time, rival agencies Moody’s and Fitch both currently have AAA ratings for U.S. credit, but with negative outlooks. And if this is not another area of confusion for investors, then I do not know what is.


Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media.
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