Economic Update—September 18, 2013

By Steve Scranton, SVP, CFA
Chief Investment Officer

Federal Reserve Update

The Federal Reserve (Fed) surprised the financial markets today by announcing that they were maintaining the level of bond purchases that they have been making since the beginning of the year. Most economists and market participants had concluded that the Federal Reserve would reduce the level of bond purchases and that the only question was the size of the reduction.

In explaining their decision the Fed had the following to say:

“Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.”

Basically, the Fed said that the economy was improving but that they were not comfortable that the improvement had reached a level where the improvement would continue. Economic data in late August and September has shown the pace of economic growth slowing and that appeared to cause sufficient concern from the Fed to warrant waiting to see if this is a temporary slowdown or something more serious. It appears that the Fed does not want to risk starting to reduce their purchases and then need to reverse course and increase them again if the slowdown worsens.

The Fed also reminded the market that it is the economy that will determine when the Fed will begin reducing their purchases, not the investment community, the Administration or Congress. The Fed once again tried to clarify their intentions by stating the following:

“In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases.”

Economic Update

The news caused prices for both fixed income and equity securities to increase.

  • Fixed income security yields fell (prices rose) due to relief that the Fed would continue to be a strong buyer of Treasuries and mortgage-backed securities (MBS). From a basic supply and demand standpoint, this is positive for fixed income prices because the demand from the Fed will remain the same (rather than declining) while the supply of Treasuries and MBS is slowly declining. Treasury supply is declining because of the reduction in our national deficit while mortgage supply is declining due to higher mortgage rates and lower refinancing activity. This is a fundamental supply and demand issue.
  • Stock prices rose due to relief that the Fed will continue to buy bonds. This is more of mix between an emotional response and a fundamental response. The stock market appears to believe that the “T.I.N.A.” effect will remain in place. T.I.N.A. stands for: There Is No Alternative. The thinking from the stock markets is that continued Fed purchases of fixed income securities will continue to deprive investors of income and that the only alternative is to buy equities.

Today’s decision by the Fed does not change the message from the Fed. The Fed has made it clear that they intend to begin reducing their bond purchases at some point in time and that Quantitative Easing is not a “forever” situation. What changed is that the starting point for reducing purchases has been pushed out. As a result, expect continued high levels of volatility in the investment markets.