Fed Forecasts End of Monetary Easing, Sending Markets Into a Tailspin

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Bernanke pulled out all the stops in an attempt to combat the long economic malaise (Public Domain).

Bernanke pulled out all the stops in an attempt to combat the long economic malaise. Photo courtesy of the United States Federal Reserve.

Now, this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning — Winston Churchill.

A few parsed words by Federal Reserve chairman Ben Bernanke last week spurred long-term interest rates to rise by their most significant amount in over four years, as the era of the Fed’s historically-generous monetary policy appears to be finally winding down.

On Thursday, Bernanke held a news conference in which the typically-reticent chairman rocked the equity markets by discussing the Fed’s plans to begin tapering its $85 billion per month in securities purchases, divided evenly between mortgage-backed securities and treasuries. He indicated that purchases could start to diminish later this year, with the program coming to an end in 2014.

Fed’s Quantitative Easing: What Was The Point?

The Federal Reserve enacted an aggressive, longstanding campaign to fight the sudden economic calamity that struck the United States in 2008, starting with its first round of Quantitative Easing in November of that year. Simply put, the Fed began injecting liquidity into the system by purchasing securities and holding them within its balance sheet. That increased liquidity sent interest rates downward, eventually helping to spark growth by lowering borrowing costs.

Interest Rates and Quantitative Easing

The 10-year treasury stood at 4.01% on October 31st, 2009, just before Quantitative Easing (QE1) began. Thirty days later, it had dropped to 2.72%, and by the end of the year was 2.25%. 30-year mortgage rates fell in concert, with average mortgage rates down nearly 1% during that same period.

QE1 continued on until March, 2010. By the end of the first round of liquidity injections, the 10-year treasury had bounced back to nearly where it was prior to the initiation of the program, as inflationary fears and general market uncertainty shaped the yield curve. Mortgage rates hovered around 5%, a sign things were not working as intended.

With the economy performing poorly and the housing market moribund, QE2 began began a few months later, this time serving to drive down interest rates in a more sustainable fashion. “Operation Twist”, QE3 and QE4 followed in 2011 and 2012, all forcing rates down to historic levels. In the end, 30-year mortgage rates declined to less than 3.35%, which helped to re-start the housing market after over four years of falling prices. It also caused a record run-up in the equities markets.

Interest Rates and the Stock Market

All else being equal, when interest rates fall, stocks rise. This is true because as bond rates fall, investors shift money into equities, a riskier, yet greater potential source of returns. QE3 in particular (in combination with other factors, including strong corporate earnings and better-than-expected economic data) accomplished that, as the Dow Jones Industrial Average jumped nearly 2,000 points between November, 2012 and May, 2013.

Likewise, the opposite is true. With Bernanke’s comments roiling the stock market, 10-year treasury rates increased nearly one full percent since April, and mortgage rates climbed to above 4%.

Although still low by historical standards, the trend is significant. Furthermore, the Federal Reserve ending the latest round of Quantitative Easing will eventually unwind the artificial damper placed upon interest rates altogether, thus allowing true market forces to take hold once again.

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