Time and again you hear speculation about the Bernanke Put and how stock prices would fall if it was not in effect. In case you are not aware, a put is a right to sell a stock at a given price, thus protecting the holder from further downside loss. The Bernanke Put supposes that Federal Reserve intervention will save the stock market from downside risk through easy money policy.
But I have been wondering lately, who is the real beneficiary of the zero interest rate policies that seem to be ineffective at jump-starting the economy? Well there is one asset class that seems to outperform without fail due to our easy money policies: I am referring to the bond market. Setting the federal funds rate at zero for a prolonged length of time has created a rush into the perceived safety of treasury bonds on a scale that is staggering. The chart below shows the declining rate of a 10 year treasury note compared to the US consumer price index. Historically, the CPI has increased at a 3.6% annualized rate. Even with moderate inflation, the buyer of a 10 year note can expect a loss of purchasing power over the duration of his or her investment. Said another way, every time a 10 year note is sold it is mathematically guaranteed that someone will lose purchasing power. However, because the market is a short term a voting machine, plenty of investors are speculating on treasuries. The appeal of investing in long term government paper escapes me. At these prices even small changes in yield can wipe out months or years of coupon payments.
Now take Conoco-Phillips (COP). They have an A credit rating from Standard and Poor's. This means that they can borrow money on the corporate bond market at remarkably attractive rates. Conoco notes due in 2039 are currently trading at a yield to maturity of 3.86%. Yet the dividend yield on their stock is nearly 5%. When the dividend yield is above the cost of borrowing it is little wonder that companies have been retiring stock through corporate debt offerings. After all why not borrow at a lower rate than your dividend yield and pocket the difference? Thus the lower growth environment we are currently experiencing has some aspects that are a boon to investors in equities. If a CFO can save money by retiring stock you can expect him or her to do it, ultimately concentrating the holdings of stockholders at the expense of bondholders.
However, other aspects of the market are not a boon for investors in stocks. The bond and stock markets are inversely correlated. Thus it is fair to assume that policies benefiting the bond market actually depress the prices of stocks. Operation twist has caused investors to rush into bonds at the expense of stocks, so how is the Bernanke Put a boon to the stock market? Ironically QE2 preceded increases in the yield of treasury bonds as investors were encouraged to take more risk in the marketplace. Neither outright monetization through new purchases nor further twisting of the Feds balance sheet accomplishes the desired goal of an improved recovery. Is there a third option?
What if the Bernanke Put were changed to the Bernanke Bluff? Why not raise the Fed Funds rate to 1% and leave the door open to further increases? Bernanke would not even have to raise interest rates further; simply by bluffing that further hikes could be on the way bondholders would be forced to be more rational. If the bond market traded down somewhat, impact on the stock market should be subdued. At the same time, home buyers and businesses who have been sitting on the sidelines might suddenly realize that interest rates will not go down forever. Then banks and borrowers would be encouraged to put money to work in the real economy.
It's just a thought, but the Bernanke Bluff might be crazy enough to work. It would be a risk, but for Bernanke and the real economy the biggest risk is not taking one.