Comments made by Fed Chairman Ben Bernanke following the Federal Reserve’s June policy-setting meeting caused a stir in the financial markets. The realization that the Fed might cut back on some of its stimulus efforts sparked back-to-back declines of more than 200 points in the Dow Jones Industrial Average.1
Economists, Wall Street, and the media may all try to anticipate potential monetary policy shifts. The odds of an expected action may be “priced into” the financial markets even before announcements are made, but surprises tend to have a more dramatic effect on stock and bond prices.
The Federal Reserve has been using unprecedented measures to help lower borrowing costs and stimulate economic growth. Recent events serve as a reminder that even the misinterpretation of Fed communications can spur episodes of market volatility.
Policy Plays
Besides keeping interest rates near zero since late 2008, the Fed has undertaken a third round of quantitative easing, essentially creating money to buy up longer-term bonds. Bernanke has stated that the central bank could begin to reduce the $85 billion-a-month bond-buying program later this year and possibly end it entirely by the middle of 2014 if the economy and labor market improve as expected.²
Bernanke has further explained that any decision to start tapering bond purchases would be separate from any action to raise interest rates, and that the Fed still plans to hold the target interest rate near zero until unemployment falls to 6.5% or less.³ Clarification of the Fed’s position seemed to reassure the markets; U.S. stock indexes later rebounded to new highs.4
Interest-Rate Reality
As the U.S. economy strengthens, interest rates are expected to rise. In fact, the expectation that the central bank could slow bond purchases this year has already pushed up 10-year Treasury yields almost a full percentage point, from about 1.6% in May to around 2.5% in mid July.5
When interest rates go up, the value of existing bond investments typically falls, which can adversely affect performance. But bonds may still have an important role to play in many investors’ portfolios — namely to help moderate the effects of stock market volatility and portfolio risk.
Applying sound investment principles may help mitigate some of the risks associated with bond investing in a low-interest-rate environment. Bonds with short-term maturities tend to be less sensitive to interest-rate fluctuations than bonds with longer-term maturities. Owning a diversified mix of bond investments may also help cushion the effects of interest-rate risk. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against loss.
Stock indexes may move up or down in response to the prospect of more or less Fed support of the economy, but individual stock prices are also tied to corporate earnings growth. Thus, many companies could benefit from a more robust economy, regardless of the level of interest rates.
The return and principal value of stocks and bonds fluctuate with market conditions. Shares, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. U.S. Treasuries are guaranteed by the U.S. government as to the timely payment of principal and interest.
Housing and the Economy
So far in 2013, low mortgage rates have contributed to a housing market recovery that has been a key driver of economic growth.6 Despite housing’s surge, U.S. gross domestic product grew at a relatively slow pace (1.7%) in the second quarter of 2013.7
Considering the overall level of weakness, economists can only guess how long it will take for the broader economy to improve enough for the Fed to tighten its policy stance. Following Treasuries, 30-year fixed mortgage rates rose to a two-year high in July, which could threaten to slow progress in the housing sector.8
The financial markets may continue to react — and possibly overreact — as the Federal Reserve assesses economic data and makes critical decisions in the coming months. Keeping a long-term perspective and making sound investment decisions based on your time horizon, risk tolerance, and personal financial goals may help your portfolio weather short-term periods of market uncertainty.
1, 4) The Wall Street Journal, July 11, 2013
2) The Wall Street Journal, July 10, 2013
3) MarketWatch, July 10, 2013
5) Yahoo! Finance, July 22, 2013
6, 8) USA Today, July 11, 2013
7) U.S. Bureau of Economic Analysis, 2013
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