Schwab posted the following essay yesterday in the wake of yesterdays fed action. The global stock markets have reacted negatively to the news embedded in the fed announcement that the economy is slow and at risk. Investors are taking such comments and other global concerns and selling off the global stock markets. Interestingly, we have yet to reach the lows that we saw back in August. So we may once again be bouncing along a "bottom." It appears that much of the selling is overwrought and more emotional than fundamental. The biggest danger of market actions like this are the potential impacts on confidence. Once again, we should remind clients that this is not the environment in which to sell long term positions. We should also remind clients that diversification is still their friend. While stocks are going down, bonds are holding their own or rising. (RGW)

 

On Strategy

Twist and Shout: The Fed, as Expected, Announced "Operation Twist"

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
September 21, 2011

Key points

• The Federal Reserve announced "Operation Twist," which was largely expected.
• The goal is to further reduce borrowing costs and push money via lending out into the real economy.
• Whether it will work is the big question … because high interest rates are not the economy's problem.

No doubt in reaction to the significant weakening of the economy over the past several months, the Federal Reserve acted as expected and announced what's known as "Operation Twist" (OT). The goal of this program, first instituted in 1961 and indeed named after the dance popular at the time, is to lengthen the average maturity of the Fed's balance sheet. The result, ostensibly, will be to lower longer-term borrowing rates, including mortgage rates.

The details Specifically, the Fed will buy $400 billion of US Treasury bonds with maturities of six to 30 years through next June. Over the same span, the Fed will sell an equal amount of shorter-term Treasuries, with maturities of three years and less. The Fed also announced that it will reinvest maturing mortgage debt into mortgage-backed securities (MBS) instead of Treasuries. This is intended to help reduce mortgage borrowing costs and stimulate additional mortgage refinancings and demand for new mortgages.

Over the past three months, the value of government agency securities and mortgages on the Fed's balance sheet has contracted by nearly $40 billion, and the move to reinvest into MBS is to prevent a shrinking of its balance sheet.

My office is adjacent to that of Kathy Jones, our fixed income strategist. We listened to the announcement together, and she had this to say: "The only surprise was that the Fed will shift nearly 30% of its $400 billion in bond holdings into 30-year Treasuries, which is more than most thought would occur at the very long end of the yield curve. This will flatten the yield curve even further. We've been using the mantra 'lower for longer' … now I guess we'll have to say 'lower and flatter for a lot longer'."

Not everyone's a fanAs has been the case recently, there were three dissenters on the Federal Open Market Committee (FOMC): Dallas Fed President Richard Fisher, Minneapolis Fed President Narayana Kocherlakota and Philadelphia Fed President Charles Plosser. They've been more "hawkish" on recent Fed decisions, concerned about the unintended consequences of extremely easy monetary policy, including inflation.

That said, the statement accompanying the FOMC's decision did note that "inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks." The statement did note additional downside economic risks though, specifically mentioning "strains in global financial markets."

50 years laterToday's OT has the same rationale as that of 1961—to stimulate a very weak economy while trying to keep inflation at bay. The decision to "sterilize" the purchases of longer-dated Treasuries with sales of shorter-dated Treasuries, thereby keeping the balance sheet at its current size, is an attempt to keep inflation at bay. Recall that both rounds of quantitative easing, QE1 and QE2, did expand the balance sheet and helped unleash a rapid acceleration of commodity inflation. The Fed had been very transparent about its desire to prevent the unintended consequences of more quantitative easing.

What differentiates QE from OT is that OT does not impact the amount of money supply in the markets and therefore the effect on the dollar, and in turn commodity prices/inflation, is more limited. By adding liquidity at the longer end of the Treasury curve and pumping up the supply of Treasuries at the shorter end of the curve, the Fed is hoping that cash will venture into the real economy.

Will it work?There are risks that the money won't find its way into the economy and create jobs, as intended by the Fed. Remember, full employment and stable prices are the Fed's dual mandates. There's legitimate fear that the Fed's siphoning of liquidity at the short end of the curve won't actually lead to increased lending in the real economy. Instead, the move could destroy yields on savings without the beneficial effect on growth, leading to a form of liquidity trap.

We've consistently expressed concern that the Fed is unable to cure what ails the economy. The problem is not that interest rates are too high, but that we're in a debt-deleveraging cycle that started three years ago in the private sector and is only just beginning in the public sector. This will take time—a lot of it—and although the Fed is not impotent, it does not possess the Holy Grail for the economy.

As for housing and mortgage rates, we're also still in a mortgage deleveraging and foreclosure cycle, and frankly, policy makers may be missing what ails the housing market. The focus has been on getting mortgage rates down further in order to stimulate refinancings and new borrowing. But as I've noted many times, it's the "real" mortgage rate that matters to prospective borrowers, not the "nominal" mortgage rate. What do I mean by that?

The math of "real mortgage rates"Back at the peak of the housing bubble in 2005, the 30-year fixed mortgage rate (the nominal rate) was about 6%. To get the "real" mortgage rate, you have to subtract the appreciation in home prices (the "deflator"). Home prices were appreciating at a 17% annual rate at the bubble's peak. So, the real mortgage rate was actually -11%: 6% - 17% = (11%). No wonder we had a bubble … who wouldn't want to borrow at negative rates? You could borrow at 6% to buy an asset appreciating at 17% per year.

Fast-forward to the trough in housing in 2009. The nominal 30-year fixed mortgage rate had dropped to 5%, but home price appreciation became depreciation at an ironic 17% rate. So, the real mortgage rate was actually +22%: 5% - (17%) = 22%. Who wants to borrow at any rate to buy a rapidly depreciating asset?

I think this is what many policy makers are missing. It's the "rapidly depreciating" part of the equation that needs to heal. If home prices are still declining, even with rates low, there's likely to be limited demand to borrow. I do think mortgage refinancings could get at least a marginal lift from OT if rates go lower, but we need to be realistic about the overall affect on housing.

Confidence is keyUltimately, confidence has to improve before we're likely to enjoy any reasonable pace of economic growth. Whether this move by the Fed starts the confidence-healing process remains to be seen. But we suggest you keep your expectations relatively low.

Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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