Will Federal Reserve Statement on Longer-Run Goals Free Market?
Is the period of Federal Reserve intervention in the bond market finally over?
Let’s hope so.
Ever since the 2008 collapse in the housing market, interest rates have been manipulated to keep them low. The Fed has used every tool in its tool bag to do this, including outright bond purchases in the open market.
If you understand that interest rates are the cost of money, you know this policy has distorted pricing and asset values throughout our economy. You also understand that there are both short-term and long-term ramifications, which will continue to influence the markets and economy long after the policy’s purposes end.
It’s just difficult to quantify.
How much of the appreciation seen in stock prices is due to strong earnings? How much is due to low interest rates?
Is the persistent strength we’re seeing in the housing market due to strong labor markets and income growth (pre-pandemic)? Or, is it because the cost of mortgage financing is so low?
A strong economy supports both higher stock prices and a strong housing market; low interest rates do the exact same thing. The question becomes: how much of today’s strong stock and housing markets are based on fundamentals, and how much of it is due to rates being kept artificially low?
We’d submit to you that this is the most important question investors face today.
But even on the policy-makers side of things, some very complex issues are arising. The Fed is clearly perplexed as to why, after huge amounts of fiscal stimulus and persistently low interest rates have been in place, inflation has remained low?
Last year, the Fed embarked upon a study to examine its longer-term goals and policy responses to better understand what’s happening.
Fed Chairman Powell announced the results of that study last week. His statement reminded me of the theme, “Free Willy.” This time around the Federal Reserve is attempting to free the bond market from manipulation.
The key change he discussed has to do with looking at inflation from a longer-term perspective. Previously, the Fed had a mandate that included keeping inflation in the 2% range. They were quick to respond to inflationary pressures to keep inflation from moving about that level.
Now, they are proposing that they should be willing to let inflation rise above 2%, without a policy response. They have come to believe that as long as the economy is expanding and people are working, they shouldn’t be so quick to pull away the punch bowl.
Central bankers, according to Yahoo Finance, even admit to errors when they hiked interest rates in 2015-2018. Now they see the result of their action was to create a temporary slow-down in economic activity, but without any issue of inflation becoming a problem. In other words, their models that predict the transmission between policies and inflation seem to have been wrong. They were hurting the economy and with it workers, with no measurable benefit.
In layman terms, the Federal Reserve will be inclined to let market forces more freely determine bond prices and interest rates. The Fed will intervene less.
A hands-off approach is long overdue and will be more than welcome.
The market reaction to the announcement was strong and swift. The 10-year Treasury was trading at a gain of 3/8 before the news but then sold off to the tune of 1/2 point an hour after according to Bloomberg.
So, what does a “freely trading” bond market actually look like? It’s been so long many have forgotten.
Prices are determined by matching supply and demand. That’s been the problem with Federal Reserve buying bonds in the market: we lost information on the true price of a bond.
The new issue calendar will matter again. So, too, will the supply in the secondary market.
Do you remember what happened to the bond market in March when the lockdown created an instant recession? Bond funds flooded the market with supply as managers raced to raise cash to meet redemptions. Prices collapsed and rates shot higher.
It took the Federal Reserve becoming the buyer of last resort to stabilize the market.
In a hands-off world, the market will be required to find balance in the face of normal market pressures. That’s what free markets are supposed to do.
Bond market participants will have to work harder analyzing underlying credits, but those that do will be rewarded for the work in a free market.
Although no one knows with certainty how things will transpire, we can speculate that a freer bond market will help rates move higher as we emerge from this crisis. We just cannot envision private investors accepting rates at current levels for long.
Now the question will turn to the Fed’s determination to stick to this new policy course. We all know too well those political pressures to “do something” in the face of short-term problems have been hard for Washington to ignore. Will the Fed stick to their guns when politicians demand action? We’ll see.
If you would like to discuss more how a freely operating bond market will impact your portfolio, please give me a call.