No one knows if the Fed's aggressive 75-basis-point cut in interest rates on Tuesday will soothe the markets and stabilize the economy. But slicing the price of money so deeply in one fell swoop rearranges risk, creating new opportunities and new pitfalls in the process.
Let's start with the suspicion that the central bank's latest easing was motivated by the tumble in stock markets around the world. The case looks fairly compelling. With only a week before the regularly scheduled FOMC meeting, when a rate cut was widely expected, the Fed lowered its key Fed funds rate early, and deeply. Was the move solely about shoring up a weakening economy? Partly, although there's more to the story. Otherwise, why didn't the Fed cut last week? Was there some new economic news moving to Fed to action? No, but stocks around the world were collapsing, and so the central bank decided to minimize the damage on Tuesday, the first day of U.S. trading since Friday.
No central bank can afford to ignore the signals emanating from financial markets. But there's a fine line between ignoring and pandering. Only history will decide if the Fed is deploying monetary policy judiciously in pursuit of balancing its dual mandate of maximizing economic growth and minimizing inflation. Meantime, it's hard to shake the suspicion that the Fed's reacting to Wall Street rather than Main Street. Correct or not, the central bank can't afford to let such a perception take root without creating a bull market in expectations that the Fed ultimately can't satisfy.
Ill-conceived or not, the Fed cut is reality, and when you slash rates that much that fast the action reorders risk. One example is REITs, which popped yesterday amid falling stock prices. On Tuesday, the Vanguard REIT Index ETF (NYSEARCA:VNQ) jumped 2.3%. Not bad on a day when U.S. stocks fell more than 1%. Why were REITs a safe harbor on Tuesday? Some of it has to do with the fact that real estate securities have been declining for some time. Perhaps more important is that the relatively rich yields in REITs suddenly look that much more alluring in the wake of a massive rate cut.
Speaking of income, bonds also enjoyed a boost on Tuesday, as one would expect when interest rates fall dramatically in a single trading session. Demand for the benchmark 10-year Treasury was brisk on Tuesday, pushing down its yield to 3.48%, the lowest since July 2003. In fact, the 10 year's yield is now within shouting distance of the generational low of 3.07% set back in June 2003 - a trough that some thought would stand for decades. But with talk that the Fed will cut again at next week's FOMC meeting, the idea that the 10-year Treasury yield may yet dip to new record lows is becoming more plausible by the day.
The prospect of such skimpy yields makes us skeptical of bonds as an asset class, at least when it comes to Treasuries. Unless you're expecting an extraordinarily long and deep recession (and we don't), the idea of locking in nominal yields just north of 3.0% looks like a loser for the long haul. Yes, the comfort of owning investment grade bonds will attract buyers for the foreseeable future, and the tailwind of more Fed cuts will only enhance the attraction. But we don't see bonds at this point as anything more than a tactical weapon. Prudence requires that most portfolios hold a fixed-income allocation. But if bond prices keep rising, and yields keep sinking, we'd be inclined to rebalance by shifting money to shorter maturities and other asset classes with a more enticing long-term outlook.
Indeed, all the chatter about lower interest rates and juicing monetary liquidity inevitably raises the specter of inflation, which has been inching higher in recent history. With nominal yields so low and the possibility that inflation may be higher in the years ahead, we're increasingly cautious on bonds. The Fed, rightly or wrongly, isn't worried about inflation these days, and instead is focused on giving the economy (and the stock market) a helping hand. The assumption is that once the danger has passed, Bernanke and company can raise interest rates and soak up any excess inflationary pressure.
That's the ideal scenario, but no one should assume the central bank can pull it off. The problem is that inflation, once it takes root, isn't easily contained. Perhaps that's why investors also bid up the price of gold and inflation-indexed Treasuries on Tuesday.
Higher volatility, it seems, is everywhere these days, including securities prices and central banking decisions. For savvy investors who stay calm and keep a long-term focus, that's good news for the simple reason that reordering risk usually creates new opportunities. But don't kid yourself: profiting from freshly minted opportunities in this scenario still requires walking through a field of landmines. As such, stay calm, stay focused, keep an eye out for sale prices in asset classes and, most importantly, remember that diversification is still your only friend.