Let's Twist Again
Allianz Global Investors
By Kristina Hooper
June 25, 2012
It looks like the Fed is finally facing up to the facts.
The U.S. economic recovery has stalled and policymakers have realized that they need to step in. Despite a favorable election outcome in Greece—a renewed commitment to austerity and staying in the euro zone—the Fed has lowered its outlook for growth and extended Operation Twist. The moves signal a significant departure from its view that the nation’s employment picture was getting brighter and that additional government stimulus wasn’t necessary.
The market wasn’t impressed, however, as it does little to expand the size of the Federal Reserve’s balance sheet and it failed to encourage investors to stick with stocks. Indeed, the Fed’s announcement wasn’t welcomed with much enthusiasm. The Dow Jones Industrial Average fell 1% last week, while the S&P 500 lost more than a half of a percentage point. Still, the Nasdaq and the Russell 2000 eked out small gains. The yield on the 10-year Treasury bond finished at 1.671%, while gold and oil took a hit.
Given the run-up in markets ahead of the Federal Open Market Committee meeting, a more meaningful policy response was expected. The Fed recognized economic weakness in downgrading its growth forecast for 2012 to 1.9%-2.4% and paring its expectations for the pace of the decline in unemployment.
To refresh memories, back in April, the Fed was far more optimistic on the economy, noting an improvement in the labor market. But in its June 20 statement, the Fed cited concerns over slowing job growth, an elevated unemployment rate and a depressed housing sector. This lack of momentum was enough to rein in optimism and lower the central bank’s employment target.
In addition, the Fed highlighted strains in global financial markets, which it believes pose significant threats to the economic recovery. As a result of its dimmer economic outlook, the FOMC reiterated its expectation that it will keep rates at historical lows until at least the end of 2014. Meanwhile, the Fed will continue “twisting” by selling short-term Treasury bonds to fund the purchase of longer-term Treasuries. The goal of the program is to "put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative," which should give the economy a boost.
But the problem is that we’re in a liquidity trap. And attempts to directly—or in this case, indirectly—lower long-term interest rates have a marginal impact on economic growth since both nominal and real rates are already so low. However, the Fed says it is prepared to take additional steps to reinvigorate the economy.
Less Is Not More
Sentiment has certainly soured since the Fed’s announcement. It’s not that investors don’t think the Fed should do anything; it’s that they think the Fed should do more, especially given the threat of further shocks. They’re clearly wondering whether holding rates so low and extending quantitative easing an additional six months will be enough to pull the economy out of its doldrums. Meanwhile, those debtors who can qualify for mortgages or other long-term loans—under more stringent guidelines—are applauding. Savers, on the other hand, are fretting as their money-market assets produce negative real returns. Welcome to the world of financial repression.
Under these conditions, savers must become investors to get out of the red. If history is any guide, then there are ways to combat negative yields: investing in hard assets, low-valuation stocks and dividend-paying stocks. These asset classes have traditionally produced positive absolute returns in a negative real-return environment.
Remember, sitting in cash is far from “risk-free.” When you consider your long-term financial goals, it’s really about what you earn in real terms that matters.
Kristina Hooper, CFP®, CIMA®, is head of portfolio strategies at Allianz Global Investors Distributors LLC.
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Forecasts are inherently limited and should not be relied upon as an indicator of future performance.
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The Russell 2000 Index is an unmanaged index that consists of the 2,000 smallest companies in the Russell 3000 Index and represents approximately 10% of the total market capitalization of the Russell 3000. NASDAQ Composite Index is a market-value-weighted, technology-oriented index composed of approximately 5,000 domestic and foreign securities. It is generally considered representative of the small-cap market. It is not possible to invest directly in an index.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded blue chip stocks, primarily industrials, but including financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.
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