Ben Bernanke has spoken again, this time to clarify that he did in fact say “if:” The Fed will begin tapering if the economy continues to improve. Markets are up across the globe, because improvement doesn’t seem all that probable as we continue to slog along at a now less than a 2 percent pace in GDP growth.
This combined with the volatility we have seen over the last few weeks caused by his earlier remarks bring to light just how sensitive the market is to the actions of central banks. I think everyone knows that by now but what may be less obvious to many is that this sensitivity is not isolated to the stock or bond market. It is important for investors to understand that the Fed’s tools are not scalpels: They are not precise; they are blunt. They are not smart bombs; they are weapons of mass destruction.
Artificially low interest rates raise the value of all assets. Last year I was meeting with a prospective client who was very hesitant to invest in stocks. Her reason was that the stock market was being pumped up with cheap money. So what was she investing in? Real estate. If there is an asset that has been artificially inflated by the Fed, it is real estate. To understand why that is, one must understand what it is about low interest rates that actually causes prices to rise.
The best illustration for this is a true story from my own life. In 1993 I was still renting an apartment in Atlanta where I had just moved the year before. I considered buying a house in an area of town called Peachtree Hills. The house I almost bought was listed for $150,000 and with mortgage rates near 8 percent my payment was going to be approximately $1,500 per month. I didn’t buy the house. Fast forward ten years and a friend of mine bought a house in that neighborhood – not the exact same house but a similar house. She paid more than $500,000. Her mortgage payment on her low rate Libor interest-only loan was a little less than – that’s right – $1,500 per month. The prices for houses in that neighborhood, like many desirable locations, had gone sky-high…or had they? The monthly payments actually being paid had not really changed. Low interest rates and creative mortgages made it possible to borrow a lot more money for the same payment and, let’s face it, most home buyers start and end with one question – what is the monthly payment? The housing bubble was inflated by low interest rates and consumers who bought homes based solely on what they thought they could afford on a monthly basis, which had not changed nearly as much as the supposed value of the homes they were buying.
Low interest rates inflate all assets, but especially assets that are purchased using debt. In other words: real estate. The brightest spot in our economy over the last several months has been real estate. Ben Bernanke mentioned tapering their quantitative easing program and mortgage rates have shot up a full percent. This makes one wonder: Is the real estate comeback for real or is it Fed induced? I don’t know the answer. I don’t think anyone knows the answer but we are likely to find out soon.
In the meantime I do know this: Fed policy may create short-term trading in the stock market and changing policy may create volatility, but stock values are ultimately tied to earnings. While some industries, like banking, have earnings tied closely to Fed policy, most do not. If interest rates do continue to rise, stocks will likely fare better in the long term than other assets.
Chuck Osborne, CFA
Managing Director
