Have you been to a playground recently?  See-saw’s are less common than ever and have given way to more complex playground equipment, but I think the image of an old-fashioned see-saw will help you visualize my point in this week’s market commentary.  The first see-saw I’d like you to imagine is this: When stock prices are rising, bond prices are falling.  The other see-saw I want you to visualize is this: If bond prices are up, then bond yields (interest rates) are down, and vice-versa.

Bonds, Treasuries, Stocks, and Decisions….

Let’s take a walk backwards…The Fed wants interest rates low.  We know this because they have stated as much.  They have also played their own ponzi scheme in expanding the money supply to epic levels to buy treasuries.  One purpose in buying treasuries is to keep rates low.  Low rates allow the “too big to fail” banks to stay around longer, they keep mortgage rates lower, help levitate stocks, and supposedly help businesses.  The problem is the Fed has stopped treasury purchases as of 6/30/2011.  

The image above outlines the dynamics of the see-saw analogies. In the first image, we have the stocks to bonds see-saw showing the inverse relationship between stocks and bonds.  In the second image we have bonds and their price to yield inverse affect.  Note that bonds must be down in the left image and up in the right image.  How on earth can that happen?  “Fed Magic” would be the answer.  In a true price discovery environment, buying bonds would be a negative to stocks because it would reflect investor preference over stocks.  In this Fed “goosed” environment, the Fed has been the buyer freeing up (forcing by way of punishingly low rates) investors to look elsewhere.  In essence, they are breaking the see-saw on the left allowing stocks and bonds to be up at the same time.  This is why you hear some market realists state that the stock market is levitating.

Since the Fed is ceasing the purchase of new bonds, investors who do not like the yield (interest rate) they are offered by the treasury, will ask for higher yields.  Rising yields spell lower bond prices, and lower bond prices means higher stocks.   But, rising rates will really crush the economy in the short and medium term, which would tank stocks.  In a way, letting rates rise now would lend to the reverse of the current unnatural condition we find ourselves in.  Instead of rising bond prices and rising stocks (what we have now) we will end up with rising rates and falling stocks (a formerly unnatural condition).  The dilemma for the Fed is going to be how to keep rates low.  They have two choices which are let stocks tank, or start buying bonds again.

Swaying markets

The Fed can easily sway the public and politicians to their side by doing exactly what they are doing by stopping the bond market support.  Over the next few months, if rates rise and markets fall, people will be begging the Fed to come back, versus vilifying the Fed for their manipulation of the economy.  I am not in the prediction business, but I would bet that the debt ceiling is raised by the Aug. 2nd deadline.  As well, I would bet that the Fed will have to step in to push rates down, versus letting the stock market tank and watch their magic wealth affect dwindle.  This summer will have a lot to say about where things are headed.

As I analyze my investment strategy each day and research the market players, I continue my cautious approach and (regardless of Fed decisions) trust in the strategy I’ve implemented for my clients.

Do you have an investment strategy that seeks to protect your portfolio against volatile economic times?  Call me to schedule a free review of your current investment portfolio – 913.693.7918.

John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals.  For more information, visit http://www.chladekwealth.com.

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