The Words Federal Reserve Chairman Bernanke Said That Turned The Markets Into a Tailspin

Bonds, bonds, bonds. It’s all about bonds. For those of you who don’t invest in bonds, they function in a special way. When the yield (interest paid) on bonds goes down the price of the bond goes up. When the crash of 2008-09 occurred, seven trillion of wealth disappeared almost overnight. The US Federal Reserve is like the bank of last resort and functions like a central bank in other countries. There were no more options open to stop the bleeding from the crash. The only answer was to pump money back into the economy and quickly. The way to do this was for the Federal Reserve to buy bonds and mortgage- backed securities from the banks and mortgage companies. The two largest holders of mortgages are Fannie Mae and Freddie Mac. They hold about 80% of all US mortgages.

In 2009 the Fed started the most daring and biggest stimulus in US history. They embarked on a program of buying bonds from our largest banks and mortgages mainly from Fannie and Freddie. Many of the mortgages that Fannie and Freddie held were near worthless as they had been written for owners who simply could not afford the payments. That caused massive foreclosures and a near collapse of the housing market. The various stimuli were called “quantitative easing” and have been in place throughout the past four years. The Fed buys bonds from the “primary dealers” (large banks) and credits their balance sheets. That means that suddenly the banks have new money that they can lend or invest. Very little of this money went into lending. Most of it was hoarded by the banks and used to invest in the stock market. This, essentially, is what drove the market to new all time highs in the Dow Jones Industrial Average. The sheer size of the stimulus is mind- boggling, some 3 TRILLION dollars and still going. The most recent stimulus is for buying $85 BILLION per month of bonds and mortgage backed securities. This bond buying frenzy drove prices to all time highs and correspondingly drove yields (interest rates) to all time lows. It was scheduled to continue through 2015.

June 19, 2013. Mark this date in your record book. With no advance notice Ben Bernanke announced that he plans to taper (reduce) bond buying by the end of this year and end the program altogether by the middle of 2014. The news took markets around the world by surprise causing massive liquidation of both bonds and stocks. In the week ending June 26, central banks around the world dumped a record $32.4 billion bonds (FT). Private investors sold $23.3 billion. US funds liquidated $10.6 billion and emerging markets sold $5.6 billion. Reaction to the selling caused interest rates to go up. At this point there is no way of knowing which governments sold their bonds. This will have to be sorted our in the next few weeks.

What is not clear is whether or not the heavy selling will continue over the next few months. Keep in mind that in addition to the stimulus the Federal Reserve is financing our debt. If a spike in interest rates occurs it will be more expensive for the Fed to keep issuing bonds. US mortgage rates will rise. The benchmark for mortgage rates is the 10- year note. If you follow the 10- year you will see what effect the interest rates will have on mortgage rates. Carry this a step further and you could have a retrenchment in the housing market.

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