The Fed's Hokey Pokey Plan

(Taken from the Week Ahead Section of Stock World Weekly)

The Fed announced its upcoming schedule for “Operation Twist.” The Fed plans to buy approximately $44 billion long-term treasuries funded by its sale of approximately $44 billion short-term bonds in October. While this program was named after the dance craze of the early 60’s, a more appropriate name might be “Operation Hokey Pokey,” since it is a simple program of exchanging short bonds for long bonds, or in other words “you put your short bonds in, you pull your long bonds out, you put your short bonds in and you shake them all about.” 

One of the purported beneficiaries of the Fed’s policy is the housing market because “Operation Twist” is expected to push interest rates down for home mortgages, which will (hopefully) put more money in homeowners’ pockets, and ultimately the economy at large. 

The housing market can use the help. A recent survey of economists, analysts and real estate professionals concluded that the “housing market remains shaky and is unlikely to deliver significant growth in prices over the next five years.” On the other hand, many question the wisdom of the Fed’s intervention. Robert Shiller, cofounder of MacroMarkets, opined “markets and government institutions are visibly struggling to respond consistently to an unprecedented rash of crises and conflicts. These struggles diminish confidence, which compounds the underlying economic stresses and lowers expectations.” (Five more years of housing problems, with some stability in local markets)

Paul Craig Roberts questioned the potential efficacy of the Fed’s Hokey Pokey program. In Saving the Rich, Losing the Economy, he wrote, “The Federal Reserve announced that the bank would purchase $400 billion of long-term Treasury bonds over the next nine months in an effort to drive long-term US interest rates even further below the rate of inflation, thus maximizing the negative rate of return on the purchase of long-term Treasury bonds. The Federal Reserve officials say that this will lower mortgage rates by a few basis points and renew the housing market.

“The officials say that QE 3, unlike its predecessors, will not result in the Federal Reserve printing more dollars in order to monetise US debt. Instead, the central bank will raise money for the bond purchases by selling holdings of short-term debt. Apparently, the Federal Reserve believes it can do this without raising short-term interest rates, because back during the recent debt-ceiling-government-shutdown-crisis, the Federal Reserve promised banks that it would keep the short-term interest rate (essentially zero) constant for two years.

“The Fed’s new policy will do far more harm than good. Interest rates are already negative. To make them more so will have no positive effect. People aren’t buying houses because interest rates are too high, but because they are either unemployed or worried about their jobs and do not see a recovering economy.

“Already insurance companies can make no money on their investments. Consequently, they are unable to build their reserves against claims. Their only alternative is to raise their premiums. The cost of a homeowner’s policy will go up by more than the cost of a mortgage will decline. The cost of health insurance will go up. The cost of car insurance will rise. The Federal Reserve’s newly announced policy will impose more costs on the economy than it will reduce.

“In addition, in America today savings earn nothing. Indeed, they produce an ongoing loss as the interest rate is below the inflation rate. The Federal Reserve has interest rates so low that only professionals who are playing arbitrage with algorithm-programmed computer models can make money. The typical saver and investor can get nothing on bank CDs, money market funds, municipal and government bonds. Only high risk debt, such as Greek and Spanish bonds, pay an interest rate that is higher than inflation.

“For four years interest rates, when properly measured, have been negative. Americans are getting by, maintaining living standards, by consuming their capital. Even those with a cushion are eating their seed corn. The path that the US economy is on means that the number of Americans without resources to sustain them will be rising.”

Nest Egg

Lee Adler of the Wall Street Examiner reported on unusual activity in the Treasuries markets recently. He wrote, “Foreign central bank dumping of Treasuries and Agencies reached record levels this week, far beyond anything seen in the 9 years since I started tracking this data. The last time anything remotely similar happened was at the top of the bull market in the summer of 2007, and those levels pale by comparison with what is going on today. Furthermore, this is no flash in the pan. This has been going on for 4 weeks, and has been growing for the past 3. Over the past 9 years, there has never been a time when FCBs were sellers of their Treasury and Agency debt for 4 weeks in a row. I do not believe that the bull market in bonds can survive under these conditions, regardless of what the Fed does. If the runs on European banks, bank paper, and sovereign debt subside, by even a little, it’s over.

“Furthermore, this withdrawal of FCB liquidity from the US market, combined with no net new liquidity from the Fed, should keep stock prices under pressure. For months falling stock prices have gone hand in hand with rising bond prices and falling yields. Any reversal in the trend of bond yields may not be accompanied by a similar reversal in stock prices, or at least not to the same degree. We need to be alert for any signs of a shift in these correlations in the weeks ahead.” (Foreign Central Banks Massively Dump Treasuries)

America for Sale

We will also be keeping an eye on the U.S. Dollar, which had been running in a channel between 73 and 76 from April through early September. More recently, it broke higher into the 76 to 79 range. Phil wrote, “We anticipate the rising Dollar to adversely effect the earnings of companies that earn a lot of revenues overseas. Clearly in this environment, it is very difficult to push through price increases and, if revenues are the same in Euros, then they will be lower when the company reports them in Dollars – a simple enough premise.”

The big question of the day is, are we going to see a strengthening economy, or are we going to backslide into recession? Many are thinking the latter. EconMatters sees multiple reasons that the economy is already contracting, including the falling prices of oil, cotton, copper and the S&P 500. (4 Market Signs Signaling a Recession)

And what about the stock market? Phil wrote, “Keep in mind, we are still around 2/3 cash in our (virtual) allocations. That keeps us flexible but it’s no reason to be careless. Our main job, as we retest the bottom of our range for the forth time since early August, is to decide if “this time is different.” Is this case the same as 2008 when the Global Economy is going off a cliff and we can just throw VALUE out the window as panicked traders sell their stocks at any PRICE? Or is this another opportunity for us to be greedy when others are fearful, and pick up some great VALUES at low PRICES?

“With 500-point weekly swings and 1,000 point monthly swings since July – it’s a fantastic market to trade in but you have to have that balance and, if we do begin to fail our major supports – we also have to have restraint because what looks like a bargain today may not seem like one after Greece defaults or a major bank fails or AAPL misses earnings or some other kind of major catastrophe.” (Weekend Update – Are We Bear Yet?)

As always, determining the difference between “price” and “value” is critical for making good trading decisions in the markets. For now, we’re not quite bearish yet, and since our current strategy of “cashy and cautious” has been working for us, we’ll continue to stick with it until it makes sense to change our stance.

Free trial to Stock World Weekly here >

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.