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Fed Announces New Plan; Investors Uninspired

Market Digest – Week Ending 12/14

US stocks finished the week relatively flat as Fiscal Cliff negotiations dragged on. The Fed continued to innovate. The central bank announced it will begin buying $45 billion of Treasuries per month in addition to the $40 billion of mortgage backed securities it already buys. The new purchases will be “unsterilized”, meaning they are essentially printing money rather than selling other assets. Bernanke also attempted to add clarity by stating the Fed would look to raise short term rates when either the mid-term inflation outlook exceeds 2.5% or unemployment drops below 6.5%. Investors were uninspired. Stocks and bonds both declined in the days following the announcement.

Weekly Returns

S&P 500: 1,414 (-0.3%)

MSCI EAFE: (+1.0%)

US 10 Year Treasury Yield: 1.70% (+0.07%)

Gold: $1,695 (-1.2%)

USD/EUR: $1.316 (+1.8%)

Major Events

  • Monday – Over the weekend Italian Prime Minister Mario Monti resigned, creating political uncertainty and opening the door for a possible return from Silvio Berlusconi.
  • Monday – HSBC announced it will pay a record $1.9 billion fine related to violations in supporting money laundering activities.
  • Tuesday – The White House and Republican Speaker of the House Boehner exchanged offers on the fiscal cliff, with Obama introducing the idea of raising corporate taxes for the first time.
  • Wednesday – The Fed announced it would begin a new program of buying $45 billion of Treasuries each month and tied its low interest rate policy to a specific unemployment target.
  • Wednesday – Unemployment in the UK unexpectedly dropped to 7.8%.
  • Thursday – Susan Rice withdrew from consideration for Secretary of State.
  • Thursday – European Union finance ministers reached a deal to bring many of the continent’s banks under a single supervisor.
  • Friday – A purchasing managers’ index in China exceeded expectations, indicating manufacturing activity should accelerate.

Our Take

Ben Bernanke never misses an opportunity to do something interesting. This week it was tying interest rates to specific inflation and unemployment metrics. While he retains the right to change his mind, Bernanke effectively committed the Fed to begin raising rates if unemployment dips below 6.5% (which he expects to happen sometime in 2015) or if inflation expectations rise above 2.5%. It is entirely possible neither will occur for several years, but most likely at least one of them will. That means if the Fed keeps its word, rates should rise and bond holders will take a hit.

Rarely in the capital markets is something with a high probability of happening forecast so clearly. Bonds should continue to play an important role in most portfolios, but investors must clearly understand the risks. Complacency could be costly. This is especially true for longer duration bonds and bond funds. We see an increasing amount of people owning active leveraged bond funds. Fund managers are copying the success of Bill Gross and the Pimco Total Return fund, which uses leverage. As interest rates have consistently fallen, this tactic has fueled performance. The problem is leverage can be difficult to unwind at just the right time and can lead to large losses when things go wrong.

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