I did not have to listen to Fed Chairman Ben Bernanke’s remarks yesterday to know what he was going to say. I’ve chronicled the Fed’s mentality for years on this blog. The Fed isn’t interested in reducing unemployment. It is actually interested in encouraging spending by promoting a wealth effect in asset classes.
The Fed has liberally provided support to bond valuations and suppressed interest rates by purchasing government bonds and mortgage-backed securities. Remove that demand, or even threaten to do so, and asset prices reset to a sustainable equilibrium. That equilibrium for bond valuations is much lower than where it is today.
Suppressing nominal interest rates means investors are forced to search for yield in assets besides cash savings. Investors have chased stocks. Corporate profits have historically been an average of 6% of GDP, and lately they’ve been almost twice that figure. Mean reversion in the earnings of a P/E ratio eventually affect the price as well. The equilibrium for stock valuations is much lower than where it is today.
Low rates encouraged home buyers to once again buy more house than they could afford. No one learned anything from the housing crash. Private equity firms bought up vacant homes to use as rental properties. Rising interest rates will cause them pain as home values sink to levels below what they levered up to buy. The equilibrium for home prices is much lower than where it is today.
The market is reacting predictably to the Chairman’s remarks, with stocks and bonds slumping. Addicts react badly when they can’t get their regular fix. That’s why I don’t think the Fed is serious about ending its monetary stimulus. Talking the markets down means nothing. Some black swan event will force the Fed to lose control of the yield curve no matter what it purchases.