Earlier this week the Federal Reserve ignited a firestorm in the global markets by admitting that the U.S. economy is facing downside risks. Although it continues to sugar coat the unpleasant reality, never has such a stunningly obvious statement resulted is so much turmoil.
Once again we are seeing the knee-jerk market reaction to seek refuge in the perceived safety of the U.S. dollar and U.S. Treasuries. However I expect investors will soon discover that such assets are firmly in the eye of the storm. As the tempest moves on, those enjoying the dollar's current stability may soon find themselves battered by a category five monster.
Market disappointment was compounded when the Fed failed to follow up its dire outlook with a new round of quantitative easing (QE). Instead, through a policy entitled "Operation Twist" the Fed promised to sell $400 billion of short-term Treasuries and use the proceeds to buy an equivalent amount of long-term Treasuries. The markets evidently perceived this "balance sheet neutral" policy as too timid.
From my perspective, the Twist really amounts to another Fed "Hail Mary" pass that will fall short of the end zone. But, by putting the squeeze on banks and further restricting credit availability to small business the move will likely do more harm than good.
The policy rests on the false premise moving already historically low interest rates even lower will stimulate the economy into recovery. But low interest rates are part of the problem, not part of the solution.
Even by the government's debased standards, trailing headline inflation is already hovering above 4%, and, at current rates, 30-year Treasuries are negative by 100 basis points. This distortion is inflicting untold damage on the economy. Pushing rates further into negative territory seems only to invite more problems in the future.
With the Twist, the Ben Bernanke wing of the increasingly divided Fed is offering debtors the short-term gain of low long rates in exchange for its own long-term pain of limited balance sheet flexibility and diminished power to deal with surging inflation. By selling on the short end (thereby pushing up short term yields) and buying on the long end (thereby pushing down long-term yields), the Fed will flatten the yield curve. But to attain these insignificant benefits, the plan exposes the Fed, and the economy, to great risks.
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