Twist and Shout

On Tuesday the FOMC was late in delivering it's much anticipated statement following an extended governors meeting. Apparently the wording of the final statement caused the delay. However, it should be noted that three governors voted against the statement and may have caused some of the delay in finalizing the statements language. The focus of this meeting by the markets was the Boards anticipated details on its operation "Twist", which is goofy terminology for selling short term securities and investing the proceeds in long term securities in an effort to lower long term rates and flatten the yield curve. This mechanism is meant to stimulate economic activity and resuscitate the staggering American economy. The more likely explanation for operation "Twist" is to show the public (the voting public that is) that the Fed is not standing idly by while the economy and the markets flounder. Will this latest effort achieve its goals? Only time will tell. Up to this point more dramatic actions (QE and QE2) by the Fed have not achieved their intentioned goals. It's interesting to note that typically a flat yield curve reflects a struggling economy if not outright recession. Falling long term interest rates (what the Fed is trying to achieve) reflect a market that does not anticipate growth and therefore inflation in the future. The markets could very well get spooked by the profile of the Feds desired yield curve and actually have an adverse reaction to the Feds latest actions.

What's Most Likely to Happen?

We like to anticipate what will happen so that we can look back and see how accurate (or not) we were in our assessments. Here's my take on the likely outcome of the Feds latest moves: Operation "Twist" WILL lower long term rates initially and more qualified creditworthy homeowners will be able to refinance their current mortgages and reduce their monthly obligations, more so than if nothing was done by the Fed. What is difficult to assess or establish is whether this would have occurred anyways as a result of natural market forces (investors fleeing to the safety of Treasuries) as equity markets tumble. What will not happen, unfortunately, is the Feds real desired outcome of inflating the US equity markets once again to create a wealth effect that will result in a trickle down effect that will then spur more business activity and therefore more demand for labor.

Why It Will Not Work

The Fed is trying to fix the wrong problem (slowing economic activity) using the wrong mechanism (lowering interest rates). The real problem the US finds itself with is an over-leveraged and over-burdened society that has over the last 30 or so years lived beyond its means. The Feds approach is to "fix" things so that we can all go back to doing things the way we used to. That is the wrong approach to take and it will not work. The Fed simply cannot fix this problem and it does not have the answer and should not be leaned on further to fix the economy. What the Fed can do for a start is to let the markets know that it should not be counted on for additional stimulus to inflate equity markets to create a wealth effect. Until this is done, market volatility will continue. Once investors understand that the markets must stand on their own, more realistic levels of value can be achieved and more price stability should occur. A possible outcome of this should be fewer companies trying to maintain lofty stock values to appease shareholders. The quick and dirty way to appear profitable is to cut what typically is most companies biggest expense, which happens to be labor.  Until companies reach some kind of cost/revenue equilibrium, hiring will not occur. As one of the Feds dual mandates is to maintain employment, it is in the Feds interest to let companies achieve economic equilibrium. Lower long term interest rates are not the answer to achieving this economic equilibrium.