New doubts began to surface this week on whether the Federal Reserve Bank is truly ready to stimulate the economy as early as the end of August. Given that the markets are at year highs on the anticipation of another round of bond buying, you need to ask yourself what will happen if they don’t.
The short answer is a pullback in the markets. However, any selling would be met by more buying, in my opinion. As long as the Fed continues to promise it will backstop any slowdown in the economy, investors will continue to buy stocks. The bond market may be a different kettle of fish.
Bond and stock prices have been moving in the same direction since the central bank started meddling in the markets. Normally, the prices of these two instruments move inversely: stock prices up, interest rates up and bond prices down. That is because stocks (considered risky) do well as the economy strengthens, while bonds (considered safe havens) do better as the economy weakens.
But any retiree who is depending on income from their Treasury bond investments knows that interest rates are at historic lows and have been for many months while stock and bond prices are close to record highs. So both bond and stock prices are moving in tandem.
That is because the Federal Reserve has been buying up bonds, forcing interest rates lower and lower in an effort to jump start the economy. Many believe that the only thing that is preventing those yields from rising is another round of Fed stimulus. The problem lately is that the economic data is turning a bit more positive.
Those positive numbers may convince the Fed to hold off in adding more stimulus to the economy for now and take a wait and see approach towards further action. This has resulted in a one-two punch to the prices of bonds. Some bond traders, worried that the Fed (the buyer of last resort) may not show up in August, are selling now.
Remember, too, that good economic news is bad news for bond investors. As a string of economic reports indicate the economy may not be as bad as people think, stocks appear more attractive than bonds. This had generated a classic “risk on” trade–selling bonds and buying stocks. Yields on 10-year Treasury notes rose to a three-month high to 1.803% this week before profit taking set on Friday. Some traders say yields could climb even higher, given that the high for the year is slightly below 2.375%.
As for the stock market, it could become its own worst enemy. No one knows what the Fed is thinking, but that doesn’t stop me and everyone else from trying to game their next move. Consider that we are three months away from the presidential elections. The stock market is at the year’s high and close to all-time highs. What would be the result of easing right now?
I think Republicans would cry “foul” and blame the Fed for trying to manipulate the elections. But that argument might not carry much weight at the Fed. If history is any guide, the Fed has ignored political fallout and done what they deemed best for the economy during election years.
A more serious consideration may be the level of the markets today. A QE III would send the markets even higher. I’m not sure the Fed would be comfortable fueling equity prices to all-time highs given the challenges ahead of us. In the past, the Fed announced their quantitative easing programs while the stock markets and the economy seemed to be in free fall. The averages were at considerably lower levels than they are now.
Goosing the markets now, only to see them possibly fall in a couple of months because of European worries or a lack of fiscal initiatives out of Washington doesn’t seem to be the Fed’s style. But what do I know?
We will all know soon enough, and judging from the actions in the markets, investors are still willing to bid up prices until the truth be known.
A note to my readers in the Berkshires:
I have volunteered to teach a course this fall at Berkshire Community College at the Osher Lifelong Learning Institute (OLLI). The classes will be on Mondays from 2:45-4:15 PM throughout September and October. The course, entitled “America’s Future: Buy, Sell or Hold?” will teach students to think critically about such events as this year’s presidential elections, wealth and women, our education system and much more. For more information or to sign up for the course call the OLLI Office at 413-236-2190.