How The Fed Influences Stock And Bond Markets

Due to a swift rise in interest rates, conservative portfolios have recently experienced elevated levels of volatility – the kind of shakiness that is more typical in aggressive stock portfolios. Over the last four months, the rate on the 10-year Treasury bond has risen an astonishing 130 basis points to 2.9% from a low of 1.6% this past May. To put this into perspective, an interest rate spike of this magnitude has occurred just two other times in the past decade. What’s more, all three instances took place in the last five years… during the “emergency level” monetary stimulus of the U.S. Federal Reserve (the Fed).

The first round of quantitative easing (QE1) was officially announced in November of 2008. The Fed declared that it would add a total of $600 billion to its balance sheet to curtail the effects of the financial crisis of 2008. The goal was to suppress interest rates and to help to free up the flow of credit. Shortly after the after the announcement, it seemed to have the desired effect. The 10-year dropped precipitously in a span of eight weeks; within the next six months, however, the rate on the 10-year spiked 180 basis points to the pre-stimulus level of 3.9% because banks were hoarding cash and keeping lending on a tight leash.

Rates eventually settled back down as confidence returned to the bond market. And while stocks rallied 57% from the March 2009 bear market bottom, the U.S. economy via gross domestic product (GDP) and unemployment continued to plod along.

Not surprisingly, the Fed announced additional “emergency level” monetary stimulus in November of 2010 (QE2). The central bank of the United States would add another $600 billion to the Fed’s balance sheet over the course of six months. Once more, the goal was to artificially suppress interest rates so that consumers and businesses might borrow and spend. Unfortunately, before the effects of QE2 could even set in, the 10-year spiked to 3.7% from 2.4% in as little as four months.

Again, rates would eventually cool as the passage of time boosted bond morale. By July of 2012, in fact, the 10-year hit a record low of 1.4%. Even then, the economy (GDP, employment, wage growth, etc.) could not reach a point necessary for the U.S. economy to sustain itself without emergency level stimulus. What the ultra-low rates did do, however, was create a sense that investing in stocks and bonds was easy. After all, the Fed was always in the background.

Should it be a surprise to anyone, then, that the Fed found it necessary to introduce QE3 in September of 2012? This new round of stimulus was to remain “open-ended” with a commitment to purchasing up to $40 billion of agency mortgage-backed securities per month… indefinitely.

Surely there was enough money being pumped into the system by now, right? Wrong. Just two months after the launch of QE3, the Fed more than doubled its monthly commitment to $85 billion per month. This managed to keep the 10-year mostly below 2% through May of 2013.

The overall effect that quantitative easing (QE) had on interest rates is clear. QE1, which added approximately $1.3 trillion to the Fed’s balance sheet, pushed the 10-year down approximately 120 basis points from 3.9% down to 2.6% over the course of a little more than two years. Since then, the Fed has added an additional $1.4 trillion to its balance sheet via QE2 & QE3. The net effect on the 10-year (through 9/3/2013) has actually been a 30 basis point rise to 2.9%… thanks largely to “taper mania.”

All tallied, the Fed’s balance sheet bloated by approximately $2.7 trillion. By purchasing securities with money it created from thin air, the Fed has elevated stocks prices and suppressed interest rates; the housing market and corporate balance sheets have benefited immensely. And for those investors who have remained in stocks, or who have been willing to move up the risk spectrum, they have been handsomely rewarded. As for bond investors, the road has been much rockier than is customary, but they too have benefited from the Fed’s intervention.


On the other hand, the verdict is still out on whether the Fed’s QE experiments will have the eventual effect on the real economy (i.e. genuine employment gains, wage growth, GDP, etc.) Arguably, as the above chart illustrates, Fed stimulus has been a driving force behind US stocks (SPY) returning 150%+ in just four and a half years. However, if rates continue to trend higher, the housing market could take two steps backwards. And with QE already adhering to the law of diminishing returns, the Fed may have no choice but to go the way that the Bank of Japan has traveled… quantitative easing for as far as the eyes can see.

Since “taper mania” began back in May, new home sales have dropped more than 20% in June and July, and a recent Mortgage Banker Association survey shows loan activity down by more than 50% from the May peak. Also in July, durable goods orders (orders for items meant to last three years or more) experienced their worst month in nearly a year, while a gauge of planned business spending on capital goods also plummeted.

Monetary stimulus cannot continue indefinitely because, eventually, the negatives outweigh the positives. In fact, currencies can be viewed as worthless and/or debt obligations may be viewed as unsafe. So, if the ultimate goal is to eventually bring quantitative easing to a safe halt, the Fed’s immediate goal will be to find a “happy medium” on or after September 18, 2013.

Unfortunately, historical data have been unkind to previous experimentation with quantitative easing programs. From Germany to Zimbabwe to Japan and the European Union, the outcomes of money printing to stimulate economies range from disastrous to “not yet known.” And where the long-term consequences are not yet known, many suspect a crisis or two in the making.

No matter what the long-term future may have in store, the shorter-term is likely to see an increase in volatility for both stocks and bonds. Every blip of intermediate-term Treasuries like the 10-year are having oversized impact on stocks and bonds and, until the Fed clears up its intentions, one should expect dramatic price swings.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.