The Federal Reserve was fairly quiet in their November and December meetings, but it appears the stars have aligned to accommodate further action in 2012.
The market of 2011 will be remembered as one that searched for direction, moving violently at times only to finish right where it began. The nation’s credit downgrade, in conjunction with rich stock valuations and European debt concerns spooked investors during August and September. Treasury bonds became the asset of choice, pulling the yield on the 10 year bond under the psychologically significant 2% level.
The Fed could have intervened to alleviate last year’s volatility but instead opted to postpone significant action. They offered verbal assurance of intervention if and when they deemed it necessary, but that did little to placate increasingly nervous investors. In explaining their inaction, the Fed suggested the conditions just weren’t ideal for the additional bond purchases demanded by the market.
Readers of this blog may recall our discussion of those less than ideal conditions last summer. First, there was dissension within the Federal Reserve’s policy-making committee that complicated a vote on further intervention. Second, higher oil prices were fueling inflation expectations. By Chairman Bernanke’s own admission, he needed oil prices to abate before adopting an accommodative policy that may further fuel inflation. Third, The Fed was reluctant to be viewed as responding to stock market weakness. (Though the lines have been particularly blurry of late, the Fed prefers to consider themselves an autonomous, apolitical entity unaffected by stock market volatility.) Finally, Bernanke wanted coordinated assistance from Congress to help stimulate economic growth.
With none of those conditions adequately addressed by late September, Fed instead offered “Operation Twist.” It wasn’t particularly controversial because it didn’t require the Fed to buy more bonds from the Treasury. The twist was just portfolio repositioning – selling shorter-term bonds in favor of those with longer maturities. The European crisis fueled demand for dollars at precisely the same time and the Operation’s intention of allowing homeowners to refinance yet again was largely a success.
The scheduled November and December meetings didn’t result in any action. The announcements were largely repetitions of the now familiar mantra. However, those who have been following closely may note a significant change in the conditions that once inhibited the Fed’s purchase of additional bonds.
It appears the stars have aligned in the New Year. There has been a very convenient personnel change within the Federal Reserve that effectively quiets the dissenting voice. Inflation expectations have calmed thanks to lower gas prices. The stock market finds itself on firmer footing. Congress even passed a token payroll tax holiday for two months, which is about all one could expect from that cantankerous lot.
The Fed’s specific action and timing is always a source of rampant speculation but anticipation is rising that they may consider purchasing mortgage-related bonds in the first half of 2012. Housing has been stubbornly unresponsive to a host of well meaning attempts and while this doesn’t address many of the underlying concerns, it does serve to make mortgage financing as accommodative as possible.
At least temporarily this helps to encourage the “risk-on” trade, a reference to the characterization that in this environment investor sentiment only oscillates between two extremes.
The prudent investor remains cautious. While the Fed’s propensity for suppressing interest rates with massive bond purchases is relevant, it is not justification for unbridled optimism. Initially the bond-buying program (in which the Fed prints money to buy bonds from the Treasury) was unveiled as a temporary means for stimulating a stagnant economy. It is sobering to recognize that while the program hasn’t been particularly effective in spurring economic growth, it remains the policy of choice among an increasingly short list of alternatives.