The Market's Irrational Response to the Fed

Michael Teague  |

In the wake of the financial crisis, the Fed moved to lower interest rates in an aggressive and unprecedented manner with the goal to jumpstart borrowing and economic growth, bringing the target rate down to its current record-low of between 0 and 0.25 percent.

Following Bernanke’s comments after Wednesday’s Federal Open Market Committee meeting, all indices dropped almost instantly, a sell-off that extended to markets around the world on Thursday. Meanwhile, the yield on benchmark 10-year Treasury notes jumped to over 2.32 percent, pushing to its highest level in over two months and signaling that little comfort was taken from the Chairman’s statement that an increase in rates was “still far in the future.”

Gradual improvements in the job and housing markets have been feeding speculation that the end of QE is coming sooner rather than later. With household wealth back near all-time highs, and consumers having seemingly weathered increases in payroll taxes as well as fallout from sequestration, investors have been bracing themselves for the inevitable rate-increase that is likely to accompany the cutting-back on asset purchases.

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Despite the fact that rising interest rates in the current environment are widely seen as a signal of a recovering economy, markets will have to adjust and this could have some negative repercussions for investors. Higher rates tend to make bank lending prohibitively expensive, and this in turn can hurt consumer spending as interest rates on loans, credit cards, and mortgages go up, and it can also affect businesses by making it harder to access capital.

But the more immediate impact, as is indicated by the Treasury sell-off that has been gaining steam ever since serious talk about the Fed’s removal of QE began a couple months ago, is in the bond market with the rush to leave fixed positions from the low-rate situation that has prevailed over the past few years.

It is important to keep in mind that the recent increase in Treasury yields has largely been the result of the anticipation of higher rates, but if the Fed Chairman is to be believed, rates are not going up anytime soon, and tapering seems to be defined, for the time being at least, by the weaning off of asset purchases. Furthermore, there is a temptation to speak of tapering as though it itself is some sort of crisis, rather than a confirmation that the crisis is over.

In other words, when rates eventually do go back up, as they must, it will ostensibly be because the economy has shown itself to be strong enough to handle it. The climate that has greatly favored equities over other asset classes in 2013 will likely be a good place for investors to look. 

 Still, while Bernanke has suggested a timeline for the end of QE, he also reiterated that the Fed’s exit from the economy is dependent upon the unemployment rate and the rate of inflation. While the former has been going down, it has been doing so very slowly, while inflation has not picked up significantly, so all the worry about interest rates may be very premature indeed.

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