Running Out of Bullets

Interest rates, like almost everything financial, are cyclical in nature. Yet, under the influence of an endless series of central bank monetary programs, rates have been held artificially low for five years now.

And as we’ve said before, the Fed is fighting the law of diminishing marginal returnrns. Said another way, it takes more stimulus to get less economy-supporting results. Our central bank faces an increasingly steep, uphill battle as the economy becomes saturated with stimulatory efforts.

Here’s one example of this. After being extended through the end of 2012, six months longer than originally intended, the Fed concluded its Maturity Extension Program (MEP), commonly referred to as “Operation Twist.”

And now, just 10 months later, the net results of its rates-lowering efforts have been completely undone. Take a look at this chart, showing the spread between two-year and 30-year Treasury yields.

See larger image

For orientation, a declining line in the chart above indicates a narrowing yield curve – where the yield on long-dated, 30-year Treasury bonds is falling relative to the yield on short-dated, two-year Treasury bonds. That trend prevailed between 2009 and 2011.

Operation Twist began in September 2011, with the intention of adding momentum to the trend.

Straight from the horse’s mouth:

“By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on long-term interest rates… The reduction in longer-term interest rates, in turnrn, will contribute to a broad easing in financial market conditions that will provide additional support for the economic recovery.”

As you can see, through the program’s intended end date of June 2012, longer-term interest rates were indeed driven lower. Yet rates stayed flat for the following six months as the Fed extended Operation Twist through the end of 2012.

Since the program’s end, free-market forces have widened the spread, pushing longer-term rates higher… precisely to the level we saw in June 2011, when the Fed began this particular program.

“Thanks for NOTHING,” some would say.

We can view the recent uptick in long-term rates in two ways:

  1. As a bullish signal of a strengthening economy (as it typically is, at least when central bank manipulation isn’t part of the parcel) or…
  2. As an omen of rising inflationary pressures.

Time will tell, but one thing is certain: The Fed is running out of bullets.

Adam O’Dell

Using his perfect blend of technical and fundamental analysis, Adam uncovers investment opportunities that return the maximum profit with minimum risk.