The Underwater Beach Ball Effect

beach ball underwaterRemember as a kid holding a beach ball underwater, then letting it go? It’s fun. It’s also quite unpredictable as it returns to equilibrium.

The Federal Reserve is now facing the same task with long-term interest rates. Rates have been artificially submerged since the financial crisis in 2008. Can the Fed curtail their unprecedented monetary stimulus program without major fallouts to the economy and the financial markets?

On May 22nd, Chairman Bernanke told a congressional panel that he did not foresee an immediate reduction to easy money. However, hours later, the minutes from the last Fed meeting were released. These showed a growing number of governors want to start to “taper off” as early as next month. The markets have been rattled since then. The concern is: can the Fed “taper” off the quantitative easing without damage? It would be quite a balancing act. And, we, of course, are in uncharted waters.

Things had been going swimmingly since last September. The Fed has been buying $85 billion in bonds every month, lowering the long-term interest rates and boosting economic growth. The strategy appears to be working. The economy is growing, unemployment is shrinking, the housing market is recovering and the stock market has been soaring. The Fed had promised to keep the program going until there was a “substantial improvement” in the job market. We’re getting close. However, the markets have been spooked for the last seven trading days.

On Friday, U.S. Treasuries posted their biggest losses in more than two years, pushing yields to twelve month highs. The 30-year mortgage rate rose to 3.81% nationwide. Fixed income investments of all types declined in value, particularly currencies and emerging markets.

The S&P 500 has been down over 2% since May 22 and other equity subclasses, such as international, small cap and emerging markets are down even more. Many of the liquid alternative holdings have been flat, however, global real estate is down significantly, and gold is up in the last seven trading days. It’s one of those short periods of time when almost every investment is down.

The good news is that the economy has in fact recovered sufficiently that the Fed is considering tapering off easy money. That’s great. However, at this stage, we have no idea of the timing or the results of tapering. Bond interest and stock prices are connected, though not in a simple way. If bond interest rates rise too rapidly or too high, they will raise the cost of credit for companies and stock prices will be hurt. However, if interest rates are able to return to, let’s say, 5% or 6% that might have little impact on stocks.

focus

So what’s an investor to do? Should you do something or nothing? During periods of stress and volatility we suggest you focus on what you can control and learn to roll with what is out of your control. For example, none of us can control what the Fed does, what the major media report as front page news, interest rates or market actions. What we can control is our long – term investing plan, our asset allocation and the wealth manager we use.

It’s especially important at these times to review your long-term financial goals, risk profile (risk tolerance, risk capacity, and risk perception) and asset allocation. Most portfolios need a diversified mix of stocks, bonds and alternative investments. And, they need an experienced, proactive, trusted wealth manager like DWM, who has protected and grown client assets through volatile periods, just like the one we may be encountering now. Give us a call.

Ben Bernanke’s Latest Report to Congress

Ben Bernanke reportOn February 29th, Federal Reserve Chairman Ben Bernanke gave his biannual “Humphrey-Hawkins” report on monetary policy to Congress. In short, Mr. Bernanke testified that the “recovery of the U.S. economy continues, but the pace of expansion has been uneven and modest by historical standards.”

Mr. Bernanke noted recent “positive developments in the labor market” but said that the job market remains “far from normal.” He indicated very little worry about inflation even with the recent rise in energy prices. He pointed to advanced household spending in 2011, even though “the fundamentals that support spending continue to be weak: real household income and wealth were flat in 2011 and access to credit remained restricted for many potential borrowers.”

In the housing sector, he testified that affordability has increased, however many potential buyers lack the down payment and credit history to qualify for loans and others are reluctant to buy due to their concerns about “their income, employment prospects and the future path of home prices.” Mr. Bernanke outlined increases in manufacturing production and capital expenditures, yet indicated that the consensus of the Federal Open Market Committee is that GDP will increase overall by only 2.5% in 2012. 

Mr. Bernanke indicated that the target range for the federal funds rate remains at 0-1/4% and is expected to stay near that until the end of 2014. If so, mortgage rates should stay low and C.D. rates will be just slightly above zero for the next three years. He left the door open to a new program of mortgage-bond purchases to drive long-term rates even lower.

The Fed Chairman testified that a number of “constructive policy actions have been taken of late in Europe”. He continued, “We are in frequent contact with our counterparts in Europe and will continue to follow the situation closely.” One day after Mr. Bernanke’s testimony, the Euro-zone finance ministers said they were ready to give Greece the money it needs provided a bond swap that will cut the debt Greece owes it private creditors goes according to plan this week. At the same time, European economic data released on March 1st was grim. Overall unemployment hit a 15 year high, while inflation unexpectedly accelerated.

Zanny Minton Beddoes, of the Economist speaking on NPR’s Morning Edition last week, put the potential impact of the European problems on the America recovery this way: “In the past few months, the Europeans have successfully covered their festering sore with a massive, great Band-Aid. And, now the acute crisis has turned into a chronic one. With that, we can take off the table the risk of a financial catastrophe in Europe.” Let’s hope so. We’d like to keep the momentum going on our current U.S. recovery.

For more information: http://www.telegraph.co.uk/finance/economics/9113704/Ben-Bernankes-monetary-policy-report-to-Congress.html