Why It’s All About The Fed…

My market analysis this week can be summed up in two words: The Fed.

That’s it. No, really. That’s my summary of the market this week.

Fine, I will go into more detail… but it’s true. Federal Reserve policies are affecting almost every major market.

Let’s start with the stock market. The S&P 500 reached a new high last week.

The highs came even as data indicated the economic recovery is stalled. New claims for unemployment inched up last week, potentially reversing the downtrend that had been in place for months.

Source: Federal Reserve

One explanation for the stock market’s rise is the fact that the Fed has been adding money to the economy. The next chart shows the Fed balance sheet, one measure of just how much of this is taking place.

Source: Federal Reserve

This money has also found its way into the bond market.

Of course, we usually look at bonds in terms of interest rates.

In any market environment, bonds are of course driven by the Fed. But the Fed has historically exerted pressure on short-term debt. The Fed funds rate, Its primary interest rate, is for overbought borrowings. What’s different this time is the fact that the Fed is buying longer-term Treasuries and has pushed the rate on 10-year Treasury notes to 0.65%.

Source: Federal Reserve

What’s The Deal With Bonds?

Current yields are the lowest in history. They feel low, but there is a way to demonstrate that rates are low, perhaps too low.

Investors buy bonds because they are saving for the future. Generally, they expect to get their money back when the bond matures along with interest that compensates them for inflation and a return on their investment.

Say an investor invests $10,000 in a 10-year bond. If inflation averages 2% a year, at the end of 10 years, a basket of goods that originally cost $10,000 will now cost $12,189.94. The bond should pay an interest rate that at least keeps up with inflation.

At 0.65%, the 10-year Treasury will deliver income equal to $650. An investor will be significantly worse off after inflation.

This math explains why gold is doing so well. With inflation at 1.0%, the real yield on 10-year Treasuries is -0.35%. Gold has historically done well when the real yield is negative.

The chart below proves this point — that gold prices have done well when real rates were falling or negative. In the chart, both data series were indexed to 100 in 2003 to allow for comparison on the chart. The red line is gold, the blue line is real interest rates.

Source: Federal Reserve

Looking Ahead

All the money the Fed is adding to the economy seems to be seeping into markets. That could continue, but I expect a pullback in the next few weeks as seasonals turn bearish.

The blue line averages the index’s performance for a given trading day. It’s not precise. But it warns of a significant top.

The worst month of the year is historically September. I’d say now is a time for caution, even as the Fed continues to add money to the economy.

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