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Fed Stands Pat on Bond Purchases

Market Digest – Week Ending 9/20

A double shot of Fed related news boosted capital markets this week. On Monday, Lawrence Summers withdrew his name for consideration for Fed Chairman, increasing the odds that Janet Yellen will be named. Yellen is perceived as having a more accommodative predisposition. Next, in a surprise move, the Fed on Wednesday elected not to begin tapering bond purchases. Instead, it will continue with the full $85 billion monthly program.

Weekly Returns:

S&P 500: 1,710 (+1.3%)
FTSE All-World ex-US: (+2.1%)
US 10 Year Treasury Yield: 2.73% (-0.16%)
Gold: $1,326 (+0.1%)
USD/EUR: $1.352 (+1.7%)

Major Events:   

  • Sunday – Amid pressure from within the Democratic Party, Lawrence Summers withdrew his name for consideration to be chairman of the Federal Reserve.
  • Monday – A man who had been forced out of the military after a 2010 gun arrest shot and killed 12 people and injured about eight more inside a Navy building in Washington DC.
  • Monday – The United Nations released a report which added evidence that Syria used sarin gas during attacks on August 21st.
  • Tuesday – Microsoft announced it would increase its dividend by 22% and renewed a $40 billion share buyback program.
  • Wednesday – Saying the economy had not lived up to its expectations for growth, the Fed decided to continue its $85 billion monthly bond purchase program.
  • Friday – Federal Reserve Bank of St. Louis President James Bullard said a small tapering of bond buying is possible next month and called the decision not to taper this month “borderline”. Stocks fell on the comments.

Our Take:

Whatever you think about Ben Bernanke as chairman of the Federal Reserve, he has been consistent. Almost every major decision of the last several years has been more accommodative than consensus expectation. With only a few months left in his term, the Fed surprised again by leaving the current rate of bond purchases intact.

The bond purchase program is so big ($2.5 trillion, or about $7,000 for every American, and counting) that running it at full speed for a few more months shouldn’t make much difference. Therefore, we were not at all surprised to see most of Wednesday’s stock market spike evaporate quickly.

The risk of so much stimulus is inflation. So far there has been little sign of it, leading many to conclude it is not a problem. That may prove correct, but it is a little like saying you shouldn’t buy life insurance because you’re not dead yet. The problems with inflation are: it is hard to predict, it doesn’t provide much warning, and it can be very costly. Unless you own assets that appreciate with inflation, rising prices translate into a direct reduction in your wealth.

We don’t know if historical logic (an increase in the money supply will lead to inflation) will hold true, or if it really is different this time. It is possible advances in technology are increasing productivity at a rapid enough rate to offset inflation. Japan, while not a case to emulate, has shown that aggressive monetary policy doesn’t necessarily lead to inflation. But just in case it isn’t different this time, we think investors should position their balance sheet and asset allocation to provide some protection against higher inflation even if it means sacrificing a modest amount of return.

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