US Stock Markets Reach Record Highs as Fed Remains Accommodative

The US Stock Market as defined by the Dow Industrials and S&P 500 achieved record closes Thursday afternoon.  European stocks markets are at 5 year highs, and emerging markets such as Shanghai and Bombay have rebounded 10% from the summer's lows.  The technology stock laden NASDAQ needs to rally about 32% to eclipse the dot com bubble levels of 2000.

Leading into yesterday's Federal Reserve Meeting, most economists were expecting that the Federal Reserve would reduce, or even reverse the policy of recent years of buying long dated treasury bonds.  Historically, the Federal Reserve controlled the throttle of short term interest rates by setting the Fed Funds or overnight rate.  During the last expansion (2003-2007) Fed Funds averaged 3.2% and peaked at 5.25%.  However, the financial crisis of 2008-9 was so damaging to the economy that keeping Fed Funds at an average of 0.15% over the last 5 years failed to produce the usual robust recovery.  With no leverage left at the short end of the yield curve, the Fed bought longer dated bonds, driving up the price and therefore driving down yields at the longer end of the curve.  For example, yields in the ten year range average 4.3% between 2003-2007, peaking at 5.1%, but have averaged only 1.9% over the last two years, which is good news for mortgage borrowers and corporate borrowers, hence a rebounding housing market and record corporate profits.

The problem is: every bond investor KNOWS that the current environment is an artificial environment.  When the Fed stops buying long dated bonds, or worse, starts selling its inventory back into the market, yields will pop and prices will fall.  We already saw a taste of that in June & July, when the Fed hinted that it might scale back on bond purchases.

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