I received a lot of feedback yesterday regarding my discussion on REITs and the accompanying write-up on our blog, some of which were requests to add U.S. REITs to the performance table. Ask and you shall receive…
Market Activity for August 10, 2009
FOMC
The Federal Reserve’s policy makers meet over the next two days and will likely discuss their quantitative easing measures, which helped unfreeze credit markets by holding down yields on Treasuries. When the Fed unveiled its strategy, deflation was the market’s primary concern. Now that credit costs are returning to pre-crisis levels and recovery expectations are growing, the inflationary risk posed by the Fed buying Treasuries is a bigger risk to bond prices than its exit from the market.
The market is concerned that the money printed to fund the program will fuel inflation, and we would likely see a positive reaction to the Fed’s nonrenewal of their quantitative easing program. Exiting this program would provide a clear signal to the world that the Fed is determined to control inflation before it starts. Low inflation makes Treasuries’ coupon payments more desirable, keeping yields in check longer. This is especially important during a period in which foreign buyers, particularly China, are apprehensive about the value of their investments in U.S. debt. We need these foreign buyers to help soak up the record issuance of U.S. government debt to cover the cost of putting a floor under the economy.
While ending the quantitative easing program should calm some of the inflation fears, these purchases could still lead to inflation pressures on a longer horizon and, appropriately, inflation expectations might come earlier.
The other always important topic being discussed will be the Fed’s target for the federal funds rate, which broadly influences borrowing costs. For some of the newer Daily Insight readers, the federal funds rate is an overnight rate banks use to lend to each other. The federal funds rate serves as a benchmark for all other short-term interest rates including the prime rate, the benchmark for most consumer and commercial lending, and short-term Treasuries.
Fed funds rate and stock prices
Over most of the past 50 years, changes in the fed funds rates have been a very good predictor of future stock prices. Using research from Jeremy Siegel’s Stocks for the Long Run, the table below shows the returns on the S&P 500 Index following a change in the fed funds rate over 3,6, 9, and 12 month periods. The benchmark represents an average of all the time periods in each particular sample – for example, the average of every 3-month time period between 1955-2006.
As you can see, the Fed’s actions have a dramatic effect on stock prices. Stock returns following an increase in the federal funds rate are significantly less than average, while stock returns are significantly higher than average when the federal funds rate decreases. Now, I know some people will glance at this table and think they can beat the buy-and-hold strategy by buying stocks when the Fed is lowering rates and selling stocks when the Fed is increase rates. But if you look at the entire table, this trend (like all trends) is hardly foolproof. Since 2000, the impact of the Fed’s interest rate changes on the stock market has been the complete opposite of the historical record.
Why has this occurred? It is possible that investors have become so accustomed to watching and anticipating Fed policy that the effect of its tightening and easing is already priced into the market so that the impact of Fed actions extend over a period of a few days rather than over several months. After all, if investors expect the Fed to do the right thing to stabilize the economy, these expectations will be built into stock prices far before the Fed even begins to take stabilizing actions.
Of course, there is no perfect explanation for the runs of good or bad returns in the stock market. If you spend enough time data mining, then you will find all sorts of apparent trends in historical data. As Burton Malkiel, author of A Random Walk Down Wall Street, so eloquently stated: “Technical results have been tested exhaustively…The results reveal conclusively that past movements in stock prices cannot be used to foretell future movements. The stock market has no memory. The central proposition of charting is absolutely false, and investors who follow its precepts will accomplish nothing but increasing substantially the brokerage charges they pay.”
For more commentary on the Fed funds rate, check out Cliff Reynold's Fixed Income Recap.
Have a great day!
Peter J. Lazaroff, Investment Analyst
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