Federal Reserve Decision Spooks Stock Market

June 20, 2013

Wednesday’s decision by the Federal Reserve’s FOMC to

phase-out quantitative easing caused the stock market to

soil itself.

Stock market, ETF, NYSEARCA:IYR, NYSEARCA:XLI, NYSEARCA:IYF, NYSEARCA:XLY, NYSEARCA:IWM

The long-awaited decision by the Federal Reserve’s Federal Open Market Committee on the fate of quantitative easing was finally made public on Wednesday. It was not until the 2:30 press conference held by Chairman Ben Bernanke, when the decision was announced and the stock market swooned. Because the Fed’s quantitative easing program has been levitating the stock market for more than four years, many investors were terrified by the news. A review of the FOMC Statement (which was released at 2:00) reveals no specific discussion of the decision to phase-out the Fed’s bond-buying program.

From the FOMC Statement:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

Once Chairman Bernanke began his press conference, he wasted no time getting to the subject of the Fed’s bond-buying program. When he was asked why the future of quantitative easing was not discussed in the FOMC Statement, the Chairman said that he was “deputized” to explain it at the press conference because the phase-out of the program involved too many “subtle contingencies” for the matter to be adequately explained in the prepared document.

Although the FOMC’s tentative schedule will bring a complete cessation to bond-buying in mid-2014, the Chairman explained that those who believe that the program will end at that time have “drawn the wrong conclusion” because of the contingencies involved. The Fed plans to be flexible with its timetable, making appropriate adjustments, depending on the progress of the economic recovery. The Chairman explained that the Fed will begin to scale back its bond-buying program “later this year” although the federal funds rate will remain low until 2015.

As expected, Dr. Bernanke emphasized the difference between the Fed’s plans for its bond-buying as opposed to its control of the federal funds rate. He used an automobile analogy to describe bond-buying as the accelerator and the interest rate as the brakes. The brakes will not be applied until the Fed has its foot off the accelerator.

The Chairman repeatedly emphasized that the Fed may vary the pace of its bond-buying as conditions evolve. At one point, he explained that “substantial progress” in reducing unemployment would be indicated by a 7 percent unemployment rate. As a result, the cutback may begin once the unemployment rate drops from its present level of 7.6 percent to only 7 percent – as opposed to the previously-discussed, “threshold” level of 6.5 percent. He took care to emphasize that thresholds are not triggers and that the Fed’s adjustments to its bond-buying will be made according to appropriateness.

On the jobs front, Dr. Bernanke said that in addition to the unemployment rate, the Fed would be considering the quality of jobs available as well as the labor force participation rate. He pointed out that weak wage growth demonstrates that the jobs market “is quite slack”.

After Jon Hilsenrath asked the Chairman about the reasons for the Fed’s optimistic outlook for the economy, Dr. Bernanke pointed out that because the economy is moving forward at a moderate pace despite “fiscal headwinds” (i.e. the ill-advised budget sequester) it is making a stronger recovery than the Fed anticipated. On the same note, at a later point in the press conference, Dr. Bernanke explained that the inflation rate has been lower than expected because of the budget sequester.

Reporters repeatedly focused on Dr. Bernanke’s future at the Federal Reserve. His response was “give me two days” to discuss the FOMC decision. He was particularly questioned about his “schedule conflict” preventing him from attending the Jackson Hole conference this summer. He responded that all of the Federal Reserve districts sponsor conferences and the Jackson Hole event is just one of many.

The major ETFs expected to respond to the June 19 FOMC Statement and press conference are:

Industrial Select Sector SPDR ETF (NYSEARCA:XLI) -1.39%

iShares Russell 2000 ETF (NYSEARCA:IWM) -1.23% Learn More About iShares ETFs

iShares Dow Jones Real Estate ETF (NYSEARCA:IYR) -3.00%

iShares Dow Jones U.S. Financial Sector ETF (NYSEARCA:IYF) -1.33%

Consumer Discretionary Select Sector SPDR ETF (NYSEARCA:XLY) -1.08%

Source: http://wallstreetsectorselector.com/2013/06/federal-reserve-decision-spooks-stock-market/

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