Sept. 26, 2013
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 The Fed’s recent decision to
continue its bond-buying program (“QE”) to hold down interest rates was a
temporary relief to stock and bond markets.
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.
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
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
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
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
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) 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
Bureau of Economic Analysis, 2013
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright © 2013 Emerald Connect, Inc.
Don Leander, Certified Financial PlannerTM is located in Colorado Springs. Don has been an independent financial advisor since he started his firm in 1979. The office of Financial Planning Strategies is located at 6645 Delmonico in the Rockrimmon area.