By Anthony Mirhaydari | 24 September 2009
Well, that was interesting. After the Federal Reserve announced on Wednesday it would leave interest rates unchanged, stocks initially bounded higher before abruptly shifting direction and screaming lower. The bulls gunned the Dow Industrial Average achingly close to the 10,000 level before things fell apart.
At issue wasn't the Fed's target policy rate, which affects short-term interest rates. Instead, traders were apparently concerned that Fed chairman Ben Bernanke and his cohorts failed to expand its direct purchases of mortgages and government debt. This will likely result in higher long-term rates.
You see, the Federal Reserve has been engaging in unorthodox monetary policy over the past 9 months via "Permanent Open Market Operations," or POMO. Fed traders were authorized in March to spend some $300 billion to buy U.S. Treasury debt and $1.45 trillion to buy mortgage-backed securities and debt from government-controlled housing lenders Fannie Mae and Freddie Mac. With the original budget on the Treasury allocation nearly exhausted, many wondered if the Fed will let the program expire, or renew it. Today we got our answer and Wall Street didn't like it.
This is important since not only did these purchases help the federal government continue its simulative deficit spending over the cries of budget hawks in Congress, it helped keep a lid on borrowing rates throughout the economy. Thus, we had a unique situation where stocks were rising without a concurrent and ultimately self-defeating rise in Treasury yields. To use an analogy, this is akin to enjoying a daily slice of chocolate cheesecake without an expansion in your waistline.
Despite a 57% rise in the S&P 500 since March, the yield on 5-Year Treasuries has advanced only 0.4%. During the early stages of the 2003 bull market, interest rates jumped more than 1.1%. While the difference may seem miniscule, it has a huge affect on the internal return calculations performed by corporate financial officers and trading managers. Anecdotal evidence suggests private traders enjoyed buying financial assets alongside Bernanke & Co.
On Monday, the Fed announced it had purchased $4 billion worth of mostly five-year Treasury notes. The announcement came at 10:15 am, which was the same time that stocks hit their intraday low before moving higher. The effort has also helped weaken the U.S. dollar, which the stock market likes as well since it boosts the competitiveness of U.S. exports, adding to GDP growth.
In an ideal world, the Fed would continue these efforts. There is still plenty of excess capacity in the economy as unemployment remains high, wage growth is stagnant, energy prices remain relatively low, and factories remain shuttered. But with the G20 powwow about to start, the Fed probably worried about the vocal opposition to these direct purchases voiced by our foreign creditors in China, Russia, and elsewhere.
They also feared the market's reaction to an expansion of POMO, which would require yet further increases in the money supply. The obvious results would have been further weakening of the dollar and an increase in inflation expectations— both of which would have increased long-term interest rates and cancelled out the benefits of increased POMO. Now, the equity market must operate in a more normal environment where rising stock prices result in higher interest rates. The question is: Can the economy, with its nascent recovery, handle more expensive credit?
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