Fed To Scale Back on Bonds: Aftermath and Effects

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Financial markets went into a tizzy over Federal Reserve Chairman Ben Bernanke’s statement at the rate-setting panel press conference on June 19, 2013, “If the incoming data support the view that the economy is able to sustain a reasonable cruising speed, we will ease the pressure on the accelerator by gradually reducing the pace of purchases” (Firstpost.com).

Source: ZE
Source: ZE

The statement from the Fed’s chairman has created a sense of uncertainty in the markets, resulting in higher volatility across all financial markets and financial instruments. Financial markets continued to fall on Monday, June 24, even after assimilating the news over the weekend. The Dow Jones Industrial Average tumbled 1.5%, while the S&P 500 and NASDAQ sank almost 2%. Along with the stock markets, foreign exchange markets continued to be volatile with the U.S. dollar steeply climbing amidst the tumbling of most of the other currencies around the globe.


Theoretically, the financial markets function on fundamentals of rationale behavior, but, does this mayhem over Bernanke’s statement reflect rationality in the markets?

The Federal Reserve is mandated to keep the U.S. economy on track while using monetary policy as a tool to achieve its objective. Two of Fed’s main objectives are controlling inflation and keeping the unemployment levels as low as possible. The Fed’s monetary policy aims at controlling the quantity of money in circulation through buying and selling of financial instruments, such as treasury bills, bonds, and currencies. Since the Fed has announced that it “may” start pulling the plug on buying bonds if the market data suggests continued recovery in the U.S. economy, the financial market participants took this as a hint to future tightening of monetary policy and pressure on the credit availability in the markets, which could result in increased costs for capital investments. Also, as shown in the ZEMA graph in Figure 1, most of the currencies fell against U.S. dollar on the fear of reduced dollar distribution.

Many analysts, like CNN Money’s Melanie Hicken and Ben Rooney, described this market behavior to be irrational and temporary. The most convincing argument is the fact that the monetary tightening will happen only if market data shows continued recovery and the reduction in the Fed’s bond buying will be gradual, not a sudden end to its current $85 billon/month budget. If, in fact, the U.S. economy keeps growing and the Fed gradually reduces its activity in the bond market, then the gap in money circulation will most likely be filled by increased consumer spending, which already is showing signs of recovery. The panic of financial markets is reflected in CNN Money’s Fear & Greed Index, which plunged to extreme fear values and continues to stay there since Fed chairman made his announcement.

Source: CNN Money

Other than the financial markets, the announcement has implications for interest rates. Though short-term treasury bonds continue to provide near-0% interest rates, the long-term bond rates are showing an upward trend, affecting credit and mortgage interest rates. Also, consumers with strong credit histories might not feel the impact of turbulence in the interest rate market, but consumers with poor credit history could see credit card rates rise. Bernanke’s decisions will be based on the next few months’ market data, and, as we at ZE know, accessibility to right data in right time can have big implications for leading ahead or lagging behind the markets. Our data management solution software, the ZEMA Suite provides access to all sorts of market data and tools to make financial analysis easier in order to make better business decisions. Contact us for a demo to learn how ZEMA can solve your data needs, in order to stay current with today’s changing market.

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