December 20, 2013
The Federal Reserve Board has made its long-awaited announcement that it will begin to scale back ("taper," in WallStreetSpeak) its QE3 stimulus program. The last time the Fed even mentioned starting to taper back, last Spring, global stock markets and bond investors panicked and sent the markets reeling. Now, the Fed says that instead of buying $85 billion in Treasuries and mortgage bonds per month, it will only buy $75 billion, and more tapering will come as the economy continues its recovery and the jobless rate continues to fall.
With this â€śTaperâ€ť announcement, markets went up and investors cheered. Japan's Nikkei index reached a six-year high, European markets soared and U.S. stocks finished the day at new record prices.
Does any of this make sense to you? It is actually counter-intuitive.
The so-called "taper," and the QE3 stimulus program itself, are somewhat unique in the history of investment markets. To understand QE3, imagine that at the auctions where investors buy government bonds and packages of home loans, a bidder ten times the size of Goliath shoves everybody else aside and insists on paying higher prices (and, therefore, receiving lower interest) than any of the other bidders. The Fed's stated goal was to stimulate the economy by driving interest rates lower, making it less expensive for large and small businesses to borrow money, so they can build factories, expand their capacity and hire more people. The problem with this stimulus effort all along was that American corporations are already sitting on tons of cash, and have little need to borrow if they really want to go on a building and hiring spree. The companies in the S&P 500 index reportedly have a record $1.5 trillion in their coffers, up 14% this year alone. Add in the money stuffed under the mattresses of smaller companies, and the total may well exceed $5 trillion.
The Fed's mortgage purchases probably did make mortgage rates a bit cheaper for home buyers, but it's hard to tell how much. The day after the announcement, 30-year Fannie Mae mortgage rates were up 0.01 percentage point, at 4.42%. That's higher than the low of 3.31% in November of 2012, but still very low by historical standards.
Savers and long-term investors should breathe a sigh of relief that the Fed is finally easing out of the investment business. Why? For one thing, it means that economists at the Federal Reserve Board believe the economy is finally in a self-sustaining recovery mode.
For another, it means the end of uncertainty. When investors are unsure what to expect, they tend to expect the worst, which is why you will read articles saying that the taper will cause interest rates to skyrocket out of control, leading to all sorts of bad things in the economy, possibly including an alien invasion. By the (admittedly early) indications, no such thing is happening, and you can bet that Fed economists are monitoring the situation and plan to nip any catastrophe in the bud.
But at the same time, we can expect interest rates to go up over the next year or two at least, which is great news for older Americans who have been living on a fixed income with CD rates barely higher than what they would get if they stashed their retirement money in a cookie jar. However, we all know that banks raise interest rates on loans much faster than on the CDs.
For the economy as a whole, there is still plenty of cash to lend to any large company that wants it, housing is still more affordable than it was before the 2008 meltdown, and inflation is actually (and stubbornly) lower than the government's preferred target rate. Investors were wrong to panic last Spring, and they are right to cheer now as the biggest, clumsiest bond buyer in history starts cautiously easing away from the auction table.
If the tapering and interest rate changes are gradual, the markets can probably digest it more easily. Dramatic change could cause more chaotic results.
Letâ€™s be thankful for this small holiday gift! Happy Holidays from all of us to you and your family!
Edward J. Kohlhepp, CFPÂ®, ChFC, CLU, CPC, MSPA
Edward J. Kohlhepp, Jr., CFPÂ®, MBA
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