Investors Beginning To Doubt U.S. Economy

Includes: EEM
by: Calder H. Lamb

Operation Twist is sustaining artificially low interest rates but investors are beginning to doubt the US.

Operation Twist allowed the Fed to swap $267 billion worth of short term bonds for longer ones. The Fed hopes that its long term investment will create a hospitable and secure investment environment and keep interest rates low. Here is a rundown of what the Fed can purchase during Twist:

Operation Twist:

- 32% of buying will occur in the 8 to 10yr maturities

- 4% of buying in the 10 to 2 yr

- 29% in the 20-30yr

- 3% in the 6 to 30 yr TIPs

What makes the situation more interesting is that the Fed also revised its real GDP growth estimate of the US. They moved guidance down from the range of 2.4 - 2.9% to 1.9 - 2.4%. So the Fed thinks the US economy is slowing down, and it is investing $267 billion into the treasury market.

What does the market think? The market has responded favorably to the Fed's move by lowering bond yields across the board, sometimes even as low as half the coupon rate; bond prices have risen accordingly.

What does this mean for the future of the US economy? The Fed hopes that by continuing to push down interest rates, they can speed up the US economy; however, based upon the GDP guidance changes the US economy continues to slow down. The US economy still has structural problems which are impacting its ability to grow at a sustainable rate. The Fed's control over the interest rate can do very little for problems like a housing supply overhang, high consumer debt levels, and a massive trade imbalance. Luckily the world continues to require the US dollar to do business, which keeps international business inexpensive for US companies, but investors beginning to wonder if America's problems are more than a short downturn.

Unimpressed by the Fed's actions, investors continue to pull money out of mutual funds at an increasing rate. Just this year investors have pulled $58 billion out of mutual funds. Gold has fallen from its record high of $1,923.7 to just under $1,600 implying that investors are not running back to gold. The Fed hopes this means that investors are moving to the bond market in search of less volatile returns, but I am not so sure.

I see international growth ETFs such as iShares Emerging Market Index (NYSEARCA:EEM) expanding. EEM's dividend increased from 0.35 to 0.47 quarter over quarter. At 0.47 cents per share, or 1.24% yield, EEM's dividend has moved to a level not seen since Dec. 20th 2006 when it released a 0.52, or 1.4% yield per share dividend. These facts have led me to agree with Mohamed El-Erian's hypothesis he proposed in his book "When Markets Collide."

El-Erian's hypothesis is that the developed nations have evolved into debtor and consumption nations, and fund the growth of developing nations by molding them into strong export economies with deep currency reserves. The unsustainable economic situation in Europe and the inability of the US government to fix the structural economic problems here have left the "developing" countries with more stable economies than the "developed." As "developing" countries continue to improve their internal demand, investors are going to stream away from the US in search of higher yields with less risk. High yield and low risk is what all investors want, and it is what they will always search for. And remember, foresight is the father of insight.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.