By Sam Bondy
The actions of the stock market during the past few months have been mostly unprecedented. The reasons underlying the volatility of major indices ranging from the Dow Jones Industrial Average to the S&P 500, were not so much due to financial analyses, but were sparked by comments made by people such as Ben Bernanke, Chairman of the Federal Reserve.
The “go-to” benchmark in determining how interest rates are being affected by market conditions and vice versa, is the 10-year treasury-note, which is often referred to as the “risk-free rate” (because of how unlikely the U.S. government is to default). Yields have consistently been between 1.6 and 2.1 percent over the past year. However, during June, the “taper-tantrum” began. Bernanke said some hawkish (less supportive of QE) things, and the markets went wild. During early September, the 10-year note broke 3%, the highest it has been in over two years, but nowhere near the pre-recession yields of around 5%. But after the last fed meeting, yields went back down to around 2.6%.
How is this yield determined?
The Federal Reserve uses a tool called open market operations. This is where the Fed purchases treasuries from the open market, it is known as QE or quantitative easing. Trillions of dollars have been pumped into the economy under the name, QE. In its current state, the Fed buys $40 billion in agency mortgage backed securities and $45 billion of Treasuries each month.
These treasuries are bonds, which have a price, a face value and a yield. T-notes have a fixed face value, but their price and yields are determined by the forces of supply and demand. A bond’s yield runs inverse to its price so, when the demand for these bonds go up, namely the Fed buys them, so do their prices and subsequently, yields go down.
By the Fed driving these yields down, they hope to encourage investment, as the t-note yield is tied to various loan interest rates. When these rates are low, people are believed to borrow more and theoretically, spending/consumption would increase. The Fed’s guidelines for deciding whether or not to make these purchases is, in part, according to their “dual mandate” which is, to reach a target unemployment rate as well as maintain low to stable inflation.
So why does this affect the stock market?
Since people want to earn interest on their savings and treasuries provide such a low return, people are reaching for yield. Equity markets have become much more attractive to potential investors. As a result, when the Fed hints that it is going to lay-off the bond purchases, people think safe, treasury-yields are going to go up. People want to take their money out of the “risky” stock market, driving it down. The opposite happens when the Fed has a dovish stance, pro-QE.
When the Fed decides to reduce its bond purchases, it will have a profound impact on financial markets. Almost all interest rate products are tied to the tnx (10-year) in some way and its movement affects all corners of the economy.
The last Fed meeting was on September 17th and was considered by many, one of the most important meetings the decade. The FOMC’s stance on tapering, which was dovish, bolstered the stock market and lowered the tnx by over 25 basis points. Albeit this true, many people believe that equities are already, at least partially, discounted for any effects from a reduction in QE.
We speculate that when Ben Bernanke’s term is up, which is very soon, the future of the Fed will most likely be in the hands of Janet Yellen, a notoriously dovish economist. If she becomes the next Chairwoman, expect the stock market to rise and yields on the tnx to decrease.