Must-know: The Fed’s view of financial markets

Fed’s view of financial markets

The U.S. Federal Reserve released the minutes of its July Federal Open Market Committee (or FOMC) meeting on Wednesday, August 20. The FOMC participants discussed changes in financial market conditions since the June FOMC meeting.

  • The New York Fed conducts the Survey of Primary Dealers before each FOMC meeting. Median dealer expectations in July put the first rate hike in 3Q15—unchanged from June’s survey.
  • Corporate profitability increased in 2Q14, relative to 1Q14. As a result, the S&P 500 Index increased. The period was also characterized by low volatility.
  • Lending conditions were strong as corporations of all sizes and credit-ratings took recourse to debt markets. Issuance was facilitated by easier lending standards and terms. Commercial and real estate loan issuance was also strong.
  • Despite mortgage rates staying low, there were low origination volumes in the housing loan market.
  • There was healthy expansion in consumer credit—driven by higher auto and student loans.
  • U.S. banks were in a relatively strong capital position. They were boosted by the reduced use of maturity transformation and leverage. These factors boosted financial stability.
  • Concerns were raised over declining risk premiums in several asset classes. A number of Fed officials had previously voiced concerns on stretched valuations in high-yield debt and leveraged loans. These assets have undergone corrections since then. The corrections were spurred by the Argentina’s default and Portugal’s debt crisis in late July. So, the Fed’s warning appeared timely.

Implications for ETF investments

Dovish monetary conditions kept rates low. This benefited exchange-traded funds (or ETFs) like the iShares 20+ Year Treasury Bond ETF (TLT) and the Vanguard Total Bond Market ETF (BND). This also resulted in low volatility. The iPath S&P 500 VIX ST Futures ETN (VXX) provides exposure to equity market volatility.

An uptick in economic growth in 2Q14 improved corporate results. This was bullish for the S&P 500 Index listed companies. The SPDR S&P 500 ETF (SPY) tracks the S&P 500 Index.

Commercial and real estate (or CRE) loans are issued to firms constructing properties like malls and office complexes. An increase in CRE loans would imply that these firms are bullish about business conditions. This would benefit ETFs like the iShares U.S. Real Estate ETF (IYR) that has exposure to equities investing in U.S. real estate.