As elections draw ever closer, market participants are watching the Federal Reserve for more accommodative action. Since the financial meltdown in 2008, the Federal Reserve has stepped in to provide liquidity through the means of unconventional monetary policy, such as quantitative easing and Operation Twist. One of the main goals of these programs is to essentially lower longer-term interest rates by gobbling up longer-term treasury supplies (increases in bond prices decrease interest rates). In doing so, U.S. treasury yields have fallen to the lowest levels in decades, thus forcing investors to allocate capital into riskier assets offering more yield. Lower interest rates also in turn allow the population to borrow more freely, which ideally is supposed to help expand the recovery. Altogether, it would be safe to assume that by lowering interest rates and promoting investment, these unconventional methods should create and accelerate economic growth. Although this is true (this has been proven by rises in equity prices, and, albeit, a slow recovery), general knowledge and recent history is blatantly showing that the Federal Reserve is running out of bullets.
(click to enlarge)
(Chart courtesy of stockcharts.com)
The above chart is that of the S&P 500 since early 2008, showing visually the time frame when QE1, QE2, and Operation Twist (still undergoing) was in effect. Notice the equity market peaks, during the accommodative policy periods, are becoming less and less significant. In other words, the lowering of longer-term interest rates is failing to produce larger gains as it did in the past. I would expect this relationship to continue going forward for a couple reasons.
One of these reasons is that because long-term rates are already so low (the 10-year U.S. treasury note is currently yielding roughly 1.5%), any further Fed support will successively accomplish less and less to lower rates and thus spur investment and growth. Simply put, it is easier to lower interest rates when they are 5%, as opposed to near zero. Furthermore, investors are already used to the current underlying market theme: low treasury yields, flight to quality, risky global economic environment. I humbly doubt that a further decrease in yields, say to 1% on the 10-year treasury, is going to spur massive investment. In fact, the flight to quality we are seeing into treasuries, in part due to the Federal Reserve`s actions, is telling me that investors are still very worried in purchasing riskier assets.
Bottom Line
Recent unconventional monetary policy has proven to be less and less successful as equity prices barely surpassed 2011 highs. The U.S. economic recovery remains threatened, given recent global events, and investors remain reluctant to allocate capital into riskier investments, no matter the support from the Federal Reserve. Due to already extremely low interest rates, further quantitative easing or a continuation of Operation Twist, will in my opinion fail to produce much change in the market participant`s reluctance to risk. Due to my reasons outlined above, I believe a bearish outlook on risk assets, including equity (SPY), oil (USO), and risk currencies (FXE), (FXA), (FXC), is the best game plan going forward, along with a long position in quality through treasuries (TLT).
