On Wednesday, Ben Bernanke and company again befriended borrowers and remained the enemy of savers.
The Federal Open Market Committee announced plans to buy long-term Treasury bonds and sell short-term Treasury notes. Specifically, the Fed will buy Treasury securities with maturities of six to 30 years and sell or redeem Treasury securities with maturities of three years or less. The intent is to bring long-term interest rates down, closer to short-term rates. Bond experts refer to this as a flattening of the yield curve.
A yield curve plots the yields of similar bonds with different maturities. A common yield curve plots yields for three-month, six-month, 12-month, two-year, five-year, seven-year, 10-year, and 30-year Treasury notes and bonds. Under normal economic conditions, the curve will slope upward, with rates rising as the maturities lengthen. Given expectations for higher interest rates and stronger inflation in the future, investors would want a higher yield for a 10-year note than they would for a two-year note.
When investors expect slow economic growth and stable inflation over the long term, the yield curve can flatten. The flatter the curve, the less difference there is between short- and long-term bond yields. If investors expect interest rates to fall in the future, the yield curve can even become inverted, with long-term bond yields below those of short-term yields. (If you are unfamiliar with bond terminology, here is a primer.)
So why would Bernanke want to flatten the yield curve? I asked this question to Michael Hasenstab, a fixed-income manager for Franklin Templeton who spoke at the Morningstar Investment Conference. Hasenstab confirmed my initial reaction to the FOMC's announcement: Bernanke is trying to create liquidity as well as inspire confidence that he will do whatever is in his power to fend off a double-dip recession.
The Fed chairman is increasing his bet that if long-term interest rates are low enough and banks have enough access to capital, lending will pick up, thereby spurring economic growth. It is painful medicine for savers that runs the risk of leading to higher inflation in the future. It is also questionable as to whether this latest move will have any significant effect, especially since the Fed will only be able to buy $267 billion of longer-term notes and bonds. On the other hand, we can only guess what the economy would be like if Bernanke were not acting aggressively.
From a portfolio standpoint, dividend stocks can help offset the lower yields. But you should remember that bonds provide preservation of capital and therefore deserve a role in your portfolio, even if the yields remain painful.
Charles Rotblut, CFA, is a vice president with the American Association of Individual Investors and editor of the AAII Journal.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.