In September, the Federal Reserve announced that it would begin selling off its enormous $4.5 trillion portfolio of bonds. This is the clearest sign yet that the bank believes the U.S. economy is well on the path to recovery.
The Fed first began purchasing the bonds in 2009, to ease the effects of the Great Recession. Known as Quantitative Easing (QE), the bond-purchasing program served two purposes: to inject cash into the financial system and drive down interest rates. This, in turn, put money in consumer’s pockets, kick-starting and stimulating greater economic activity.
Buying government securities to manage short-term interest rates is a common strategy used by the Fed. The enormous scale of the bond purchase, however, was unprecedented.
How bonds spurred the economy back into action
It’s easiest to think of a bond as an IOU. It’s a loan that contractually defines the principal amount being borrowed, the interest rate, and the date by which it will be repaid. Because the interest payments — also called “coupons” — don’t change once they’re set by the contract, bonds are commonly referred to as “fixed income.” Their unchanging nature makes them easy to trade in the market — the buyer and the seller just need to agree on a price.
Pricing is often a function of demand. With bonds, it’s specifically driven by the demand for higher returns. A bond’s return depends on how much interest it generates (coupon interest) and how much the net gain will be when it’s repaid (capital gains).
When interest rates increase, as they have lately, fixed income investors prefer to buy newer bonds with higher coupons and sell their older bonds with coupons that reflect the earlier, lower interest rates. Demand isn’t as high for the older bonds with smaller coupons, so their prices drop accordingly. The reverse happens when interest rates fall: the older bonds have larger coupons, so they’re worth more. As a result, prices go up.
In these scenarios, interest rate movement causes price adjustments, but it’s also possible for bond demand to push rates.
When the Fed purchased $4.5 trillion of bonds, its sheer purchasing power caused bond prices — and thus, capital gains — to rise, thereby increasing returns for bondholders. New bonds could then be issued with lower coupons, because borrowers didn’t need to offer a high interest rate to attract buyers. This action drove down interest rates across the economy.
The lower interest rates also meant that companies could cheaply borrow from investors and banks to expand their businesses and hire more workers. This was a shot in the arm for the economy, helping boost inflation from dangerously low levels.
Now that the economy is back on track, the Fed is reversing course, slowly raising interest rates and beginning to unwind its massive balance sheet. Some fixed income investors lament this reversal because their bonds could lose value due to falling rates and the Fed’s bond-selling pressure. In a broader sense, though, it is an encouraging sign of economic health that the Fed has begun this process.
Easing the Fed’s foot off the gas
With more money in consumers’ pockets, the economic engine is primed for continued growth with less direct assistance from the Federal Reserve. Already, the U.S. economy appears quite strong and stable: the second quarter saw a 3.0% increase in gross domestic product (GDP) — the thirteenth consecutive quarter of growth.
Moreover, after a long period of stagnant wages, evidence suggests that an increase in income growth is on the horizon. Unemployment has hovered between 4.2% and 4.4% since May 2017, pressuring employers to increase wages as they struggle to recruit and retain workers in a tight labor market. In fact, Target Corporation recently announced a three-year plan to increase minimum retail employee wages to $15.
(Chart illustrates the year-to-date price performance of VTI, an ETF tracking the total US stock market, as of September 29, 2017; source: Google Finance)
Meanwhile, despite the occasional blip, U.S. equities continue to soar, up nearly 14% for the year. Inflation and interest rates continue to remain low, guided by the gentle nudges of the Fed’s monetary policy.
We still expect the Republican-controlled Congress to push a tax plan that benefits shareholders by reducing capital gains taxes. A tax amnesty bill allowing companies with offshore cash could also enhance stock market returns.
These economic signals suggest continued growth in the broader U.S. economy and stock market, but with a couple of caveats. First, it is nearly impossible to time markets successfully. Second, North Korea uncertainty drags on investor sentiment. Though we anticipate continued growth in US equities, a globally diversified investment strategy continues to be the right call for most investors.
Global equities outperform the U.S.
As well as the U.S. stock market has performed, international developed markets have outperformed, up nearly 18% for the year. Global stability and improving economic conditions in Europe and Japan have contributed significantly to the upswing. European unemployment continues to fall, down to 7.7%. And the re-election of Angela Merkel suggests the strong German economy will continue to lead the European Union through its tough negotiation with the United Kingdom over Brexit.
(Chart illustrates the year-to-date price performance of VEA, an ETF tracking developed market equities, as of September 29, 2017; source: Google Finance)
Emerging markets continue to be a top performing asset class this year, up more than 20% for the year.
(Chart illustrates the year-to-date price performance of VWO, an ETF tracking emerging market equities, as of September 29, 2017; source: Google Finance)
Stay the course
The U.S. stock market is enjoying a fine year, and international stocks are recovering from recent lagging performance to help boost returns. Though U.S. fixed income may soften as the Federal Reserve sells off its bond portfolio and ticks up interest rates, the takeaway is that the U.S. economy is performing well. A stronger economy means good things for bond holders, even if returns weaken.
We continue to recommend that our clients invest in a strategic, globally diversified portfolio aligned to their preferred risk tolerance and time horizon. If you have questions about what the right asset allocation is for you based on your goals, take our risk questionnaire or talk to one of our financial advisors.