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Some Investors Getting 'Fed Up' with the Fed?

As returns available on CDs, T-bills, and money market accounts continue to hover at minuscule levels, conservative investors with large sums in these accounts who currently live off the interest or expect to grow their investment for the future, are likely finding the low rates intolerable. Therefore, we suspect that many are more and more biting the bullet in their search for higher yield and stepping up to investments in bonds and even stocks.

Late in July, Fed Reserve Chairmain Ben Bernanke, in testimony before the Senate, again suggested that interest rates would remain low for an "extended period." But given that growth is currently weaker than desirable, and given that interest rates near zero cannot be cut any further, the Fed would still like to be able to respond if the economy softens from here. However, their remaining options have drawbacks, including increasing their own level of bond purchases which means they would be taking on more debt themselves, something they would rather start unwinding than increasing.

So, one action they are considering is further emphasizing that interest rates will remain low for a long time. In fact, according to the Wall Street Journal, the Fed is already "evaluating its public communications, ... exploring how to underscore to the markets and the public that it plans to keep interest rates low" (italics added). Why would the Fed be evaluating this action beyond what they have already done? Well, aside from the obvious attempt to be "transparent," they may be attempting (although only people who have actually attended their meetings might be able to 100% confirm this) to indirectly sway the direction of the markets by getting investors to take actions that the Fed deems will be helpful to the economy. In other words, the Fed might be using its position of power to "nudge" investors into bonds and stocks.

The longer interest rates remain close to zero, the more investors will likely begin to cast aside their low yielding MM accounts, CDs, or even short-term Treasury bills in favor of investments that pay a higher dividend. As a result, theoretically at least, interest rates on longer term bonds, which the Fed has no direct control over, will continue to drop since greater demand means higher bond prices, and lower yields. This will further stimulate the economy without the Fed having to do anything else. In fact, one of the weakest segments of the current economy, housing, can potentially improve as interest rates determining new mortgages and refinancings go even lower.

Of course, we likely all have come across the important notion in investing that dropping interest rates are good for stocks. This makes sense in that as returns on non-risk investments fall, investors are more willing to take on greater risk in stocks. If the stock market can get back on track, the entire economy will likely start to improve, and importantly, companies will likely be more willing to hire. Since full employment, along with low inflation, are the twin objectives of the Fed, it can be seen that by getting more investors to invest in stocks, a Fed policy of keeping interest rates low for quite a long time would help to meet the full employment objective.

And since deflation, rather than inflation, remains a scary possibility to economists as well as the Fed, an improving housing, job, and stock market, and overall economy would help to ensure that it just doesn't happen. Improvements in each of these areas would be mutually reinforcing to the others, as better employment leads to more houses sold, higher stock prices to more spending by consumers, etc.

So once again, as I believe has happened before, it appears the Fed may be subtly encouraging all of us to seek out higher returns, especially those who are in low yielding investments that do not enable one to earn any sort of satisfactory return. If so, how should one react to this enticement, whether you believe it is being done deliberately by the Fed or not?

I believe that there are several forces at work which have created, and will continue to do so, a very good opportunity for bond investors. These are: a) a new "conservatism" among stock investors as a result of virtually no, or even negative returns, over the last 10-plus years for those who bought and held; and b) investors in the above low yielding investments having become more and more "fed up" (an apt phrase given the Fed's stance) with near zero returns, now showing a willingness to convert over to bond funds which sport a higher yield.

As a result, as more money continues to flow into these investments, apparently even further encouraged by the Feds' statements, bond funds' total return prospects appear reasonably good so long as these trends continue. (Remember that total return is the sum of not only the dividend payments but also any potential capital gain that comes from an increase in the price of the investment that results from a greater demand for the underlying bonds.)

Should investors reach for incremental yields that are available by investing in long-term treasuries and/or corporate bonds? Perhaps to some extent. But especially for investors who tend to buy and hold their funds, it would probably be wiser to stick to intermediate, rather than long-term bonds. After all, eventually interest rates will go up and holders of longer-term maturities will then get "hit" by dropping prices. But we do not anticipate that happening for quite a while. After all, if the Fed is right, interest rates will remain low for an "extended period."

Of course, whether one chooses to go out of conservative investments into stocks merely to achieve their usually higher dividends as well depends a lot on one's degree of risk tolerance. Prices of stocks can be influenced by a lot more than just these kinds of switchovers, such as, corporate profitability, international developments, unforeseen catastrophes, etc. Therefore, while we think that prospects for stocks could very well be improved by the Fed's pronouncements, cautious investors perhaps will want to think twice before accepting the bait.


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