Archive for the ‘News’ Category

Department of Labor Issues Additional Guidance for Participant Fee Disclosures

May 8, 2012 – Yesterday, the Department of Labor’s Employee Benefits Security Administration (EBSA) issued frequently asked questions about the requirements of new participant fee disclosure rules in Field Assistance Bulletin 2012-2.

Field Assistance Bulletin 2012-02 (FAB) answers questions about what types of plans are covered under the regulation, including tax-sheltered annuity programs under Section 403(b). It also addresses methods of disclosing plan-related information and how to deal with revenue sharing.

“This guidance will help both plan administrators and covered service providers comply with their obligations under the department’s new fee-transparency rules, so that workers who make their own investment decisions in retirement plans will have the information they need to make informed investment choices,” said Assistant Secretary of Labor for EBSA Phyllis C. Borzi.

The DOL also expects to release another FAB that will concentrate on questions specific to covered service providers.  According to Borzi,  “We also are working on a second set of frequently asked questions and answers focused more narrowly on the new rules for disclosure by covered service providers.”  No date was specified for release of the next FAB.

We expect that there will be no further delays in the effective dates for meeting 404(b)(2) and 404(a)(5) based on the timing of this most recent FAB.  While there have been some aggressive lobbying from certain corners of the industry, it seems that DOL would like to have this completed before the November elections.

To view Field Assistance Bulletin No. 2012-02, visit http://www.dol.gov/ebsa/regs/fab2012-2.html.

Labor Department Ramps Up 401(k) Plan Exams

During the last 12 months, regulators from the U.S. Department of Labor (DOL) have quietly increased examinations of firms that offer 401(k) retirement plans, including brokerage firms, registered investment advisers and third-party administrators, according to attorneys of those firms which have been audited.  It seems they are focusing on how these companies get paid, and want to see if any conflicts of interest come out of that investigation.  A spokesman for the Labor Department said that the examinations are part of a larger effort to study employee benefits as a whole – not limited to 401(k)s, but also an inspection into health and welfare plans, according to Reuters.   Several attorneys interviewed by Reuters each said they have at least three 401(k) retirement plan provider clients being investigated by the Labor Department.  They opine that the Labor Department’s focus on the providers themselves will ramp up when the agency’s fee disclosure rules take effect on August 30th.

We expect that many employees will be surprised when they begin seeing these fee disclosures.  While the expenses may have been there all along, this will be the first time many of them become aware that they are paying a fee and some are likely to be upset about it.  “There are going to be a lot of complaints from employees who didn’t know what they were paying,” said Sheldon Smith, a member of the board of directors of the American Society of Pension Professionals and Actuaries.

The Labor Department exams also seem to be aimed at better transparency.  Though the information they yield is public, and available to anyone willing to dig through fact sheets and prospectuses on the Internet, the investigations make the information more available to those who may not know what they are looking for.

According to the Reuters article, the Labor Department has expressed concern that firms, such as brokerages and consultants, are receiving compensation that is not disclosed to 401(k) plans and, in some cases, the firms might be paid more to recommend specific investments.

Source: Reuters.  April 25, 2012

2012 Tax Matters

You can expect continued uncertainty on taxes this year, at least until after the November elections.  

Stay tuned for updates.

Dividend Stocks Favored in Sideways Market

A Look at Foreign Markets: Cheap vs. Expensive

Following dismal performance during the third quarter of 2011, the international equity markets churned around some but finally ended up 4.9%.  That is not too bad for a quarter, but it certainly was not enough to offset the damage from earlier in the year, as the final tally for the full year as shown by ETFs was -12.2%.  The following graph of the iShares ETF, which tracks the MSCI EAFE index (non-U.S. developed country stocks) tells the story.

Data Source: Bloomberg L.P.

The emerging markets seemed to be a magnified version of the developed markets as they were up 9.1% in the fourth quarter, but were down 18.8% for the full year.  Although it may have felt like this is what we were experiencing in the U.S. too, in fact US markets significantly outperformed international markets for both the fourth quarter (up 11.6%) and for the full year (up 1.9%).

Much of the outperformance can be attributed to our perceived position as the world’s safe haven.  Thus while Europe looked over the edge of the financial abyss as it stalled its way to coming up with a mediocre solution to the debt problems of the peripheral countries and Asia panicked that one of their largest customers for their export driven economies would actually fall into the abyss, investors fled to the safety of the U.S. markets.  While it is reasonable to say that the U.S. equity markets were a beneficiary of this, actually the largest beneficiary was the U.S. bond market, which was up 7.8% as measured by the Citigroup Broad Investment Grade index.

So where do the markets go from here?  Let’s take a look at Europe first.  If you were to base your forecast of the European equity markets on what you expect from their economies, things might look bleak.  The contraction in government spending that is necessary to reduce deficit spending will certainly put a damper on economic growth.  That is not only a 2012 phenomenon, but a situation that may be around for several years.  But, if you haven’t noticed already, economists make lousy market forecasters.  (Actually they make lousy economic forecasters too, but that is another topic.)  The problem with looking just at the expected economic growth in Europe is that it ignores how cheap the European equity markets are.  One simple way to measure how cheap or expensive an equity market is is to look at the ratio of the market price to the earnings of the companies in that market.  Or more simply put, look at the P/E ratio.

To set the stage for this discussion, look at the P/E ratio for the S&P 500.  It is currently 13.65.  Historically it has ranged from 10 to 25 most of the time, although it has been as low as 6 or 7 and over 30 at times.  Generally there is an inverse relationship between P/E ratios and interest rates.  So one would expect that in times like this, when interest rates are particularly low, that P/E ratios would be somewhat higher.  In Europe the broad index for large companies across the continent is the Euro Stock 50 which has a current P/E ratio of 11.  Furthermore the main indexes for Germany, France and England have P/E ratios of 10.3, 9.4 and 10.0 respectively.  So Europe is not only cheap relative to the United States, it is cheap relative to historical pricing.  We believe that the cheapness of these markets will help to put a floor under the current levels and actually allow them to grow at a modest rate as they started to do in the fourth quarter.  For U.S. investors some of that performance may be mitigated if the Euro continues to deteriorate relative to the dollar.  The recent announcement that France and Austria are being downgraded by S&P may hasten that deterioration; on the other hand the U.S. has its own economic and fiscal problems which could hurt the dollar if markets turn their focus from Europe to the U.S.

The Asian markets are a little more difficult to predict.  There are three main items that look like they will affect markets there.  First there is a mixture of cheap and expensive markets.  For example here are some of the P/E ratios: Japan (Nikkei) 16.6, Australia (S&P/ASX 200) 13.5, Taiwan (TAIEX) 16.34, South Korea (Kospi) 27.3, China (Shanghai Composite) 11.8 and India (Sensex) 14.7.  This disparity would lead us to believe that there will also be be a fair amount of disparity in the performance of the markets.

Another factor affecting the markets is inflation.  This has been a problem in Asia over the last couple of years as commodity prices have been rising.  Yet the problems in Europe have reversed commodity inflation and slowed Asian economic growth which has mitigated the inflationary problems in Asia and has given some governments the leeway to lower interest rates.  All of this is very positive for the equity markets, which have begun to respond very positively.

The last factor is the Asian economies’ ability to grow when the major economies elsewhere in the world are growing very slowly.  This is of particular concern since these economies are very dependent on exports.  Certainly Asian governments are aware of this problem and have begun to adjust their policies to move their economies to be more dependent on local consumer demand.  But this is a slow process and may take several years to evolve.
Putting all of that together, we think that the lower interest rates and the momentum of the markets from the fourth quarter will carry the day and the Asian markets will have a good year.

Putting Europe and Asia together and looking at non-U.S. stocks as a whole relative to the U.S. markets is difficult because there are so many individual markets that make up the whole.  However we believe 2012 will be a reasonably good year for the international markets and certainly an investment worthy of its position as a diversifier in most investors’ equity holdings.

Strong Evidence of Continued Low Rates in 2012

The bond market has three main issues it is talking about these days.  The first is the absolute level of rates.  The second is the level of mortgage rates and specifically whether they need to go lower to help spur the economy.  The third is whether we will be hit with a “Japanese scenario” or a “European scenario.”  The Japanese scenario is having low rates for a long time with low economic activity, while the European scenario is one where budget deficits chase away bond buyers, causing rates to climb significantly until budgets are fixed.       

For anyone keeping track, a generic portfolio of bonds (formerly known as the Lehman Brothers Aggregate Bond Index) was a better investment than the S&P 500 index over the past 10 years.  Those who dumped their 7% long term bonds for equities during the tech boom lost out.  This is a rare occurrence when the bond market continually returns more than equities.  The most recent Treasury auction for 10 year notes had a yield of less than 2% for the first time in history.  The Consumer Price Index (CPI) was up 3.4% last year.  If it stays at that level, 10 year Treasury bonds will have a negative return net of inflation in 2012.    

Last year we figured (a different author) that rates could not decline further, yet rates declined significantly.  Short rates declined to about half of what they were and longer rates declined by a third.  Two years ago, regulators told bankers to be ready for higher rates, invest short as higher rates were coming.  Banks’ earnings are being hurt by the skimpy return on those short investments as they wait for higher rates.  As a depositor, you are affected by the low rates being offered on your deposits.  So how low can rates go?  A number of Treasury auctions of short bonds have shown negative yields.  Apparently the buyers were just happy to know they will get their money back.   

We have seen a significant drop in mortgage rates over the past year.  During the early part of last year rates of 4.75% or higher were the norm.  Now rates are closer to 3.75% for a 30 year fixed rate loan.  Rates can be under 3% for a 15 year term loan.  Members of the Federal Reserve Board (the Fed) have been actively giving speeches about the need for housing to pick up.  There has never been a strong recovery without a strong housing market. There have been suggestions that Quantitative Easing 3 (QE3) will occur targeting mortgage rates and causing them to decline further.  We believe this will occur driving mortgage rates even lower.  However, the debate will be which came first, the chicken or the egg?  Is a strong housing market the result of increased economic activity or does increased housing activity create a strong economy?  Given we have had three or four years of incentives, artificially low rates and up to 16 different housing and refinance programs, it appears a strong economy leads to a strong housing market.  Before a strong housing market can appear, all the houses associated with delinquent and foreclosed loans need to be sold so a more normal market can begin.  The overhang of those houses will take over a year to clear out. 

One side note on sub-prime mortgages.  While some banks have had legal issues surrounding their role in the sub-prime mess, recently the Securities and Exchange Commission indicted the first individuals for their roles in the problem.  Those individuals were not Wall Street bankers but the heads of FNMA and FHLMC.  We have long maintained that FNMA/FHLMC dictate residential loan credit standards.  Mortgage originators like Countrywide could not originate sub-prime loans without someplace to sell them.  FNMA and FHLMC were initially the major purchasers of those mortgages.  In fact, both those corporations had mandates from the Housing and Urban Development Agency (HUD) to increase their purchases of loans made to low income borrowers.  Part of the background data the SEC collected showed that 1.) The agencies knew that to increase their purchases of loans made to lower income individuals, their credit standards would need to be relaxed, which would lead to increased defaults, and 2.)  There was very little volume of sub-prime loans until FNMA and FHLMC began purchasing them.  Once FNMA/FHLMC changed their credit criteria and began purchasing sub-prime loans, volume escalated and once it was significant, then Wall Street got into the act. 

The final question is, what will happen to rates?  While markets bounce around, we do not believe there is any reason to expect a significant increase in rates at this point.  With one exception, to be found later in this discussion.  To have rates rise, you need to have significant economic activity, fears of inflation or a lack of demand for your securities.  There is nothing to indicate that there will be additional strength to the economy going forward.  The employment situation is not good, the regulatory situation is not good and business confidence is not good.  Expectations for inflation this year are that it will fall from last year.  The Fed is targeting inflation rates between 1.5% and 2.0%.  The final item is demand.  U.S. Treasury securities are still the safe haven security despite a downgrade last summer.  With the European debacle continuing and tensions in the Middle East, there is still plenty of demand for Treasuries.   

The one exception to the low rate scenario is if the U.S. enters a European type scenario.  We call it PIIGS R US.   By that I mean the situation where bond buyers and currency traders begin to demand higher yields on U.S. Treasuries as a result of our budget deficits, the same as they are doing in Europe.  For that scenario to occur, Europe would have to come up with a final solution to their budget and entitlement problems so that the traders would begin to change their focus to the U.S.  They have been wrangling about this in Europe for two years and we expect that wrangling to continue for a while longer.  We have seen the problems in the U.S. when Congress tries to negotiate any sort of deficit reduction.  So if the focus shifts to the U.S. and our rates do start to rise, we anticipate that it will take some time for our elected leaders to figure out what to do, just as it is in Europe.

Investments and Volatile Markets

Three months ago, we shared our thoughts and approach to the wide day-to-day fluctuations in the market.  The volatility has continued and the headlines haven’t seemed to improve.   We encourage you to view this short presentation as we believe it can help investors become better prepared for the inevitable market ups and downs that occur.

Global Markets in Difficult Balancing Act

The third quarter of 2011 was one of those periods that seem to occur all too often in which the international equity markets synchronize for a downward move.  They would not get a perfect 10 for their synchronization, but with negative returns in all of the single country ETFs that we follow (ranging from Peru at -6.5% to Poland at -36.8%) it was close enough to make investors feel queasy.  Fortunately for investors, this quarter was not nearly as bad as the 2008 experience and this month we are already seeing signs of a turnaround.

The disturbing part about this downturn is that it has similar characteristics to the 2008 problem – gross malfeasance on the part of governments followed by poor judgment by bankers willing to go along for the ride.  In 2008 the problem stemmed from an aggressive push by the U.S. government to increase home ownership while ignoring the economic realities that face many first time homebuyers.  The banks transmitted this policy to the financial system, having had their arms twisted by aggressive regulators, by pushing financially untenable or unintelligible mortgages onto the weakest potential homebuyers.  The problem was inflamed as the bankers packaged those mortgages as “safe” securities and then sold them to other financial institutions and the public.

In the 2011 case, the problem stemmed from the initially flawed creation of the euro and the European central bank, combined with governments willing to cheat on their fiscal restrictions without having significant consequences and banks willing to invest in the government bonds of the errant countries.  The flaw with the euro is the disconnect between monetary and fiscal policy.  In the United States, we have one central bank and one central government.  Yet in Europe they have a central bank, but each member country maintains autonomy over its federal budget.  As a consequence, when you have a situation like we do in the United States in which federal government policies result in retarded economic growth and increased unemployment, the Federal Reserve can act as a counterweight, easing monetary policy to help alleviate the economic pain.  In Europe the central bank can only establish one monetary policy, so generally they choose a policy that is appropriate for the largest European economies, Germany and France.  As a consequence, in the middle of the last decade when France and Germany were growing modestly, the European central bank kept interest rates moderately low.  But in Ireland and Spain those low interest rates caused real estate bubbles endangering their banks in a similar fashion to the problems the U.S. banks experienced in 2008. 

Greece had a different problem:  running a budget deficit that was higher than the European rules would allow and hiding that fact from the European Union.  So Greece’s national debt began to get uncontrollably high.  Italy and Portugal had similar problems, just not to the extreme degree that Greece had, and they were forthcoming to the EU.

A separate problem brewed in Europe during the middle of the 2000’s.  All banks, whether in Europe or anywhere else in the world, are required to put aside a certain amount of capital to protect against a default when they make a loan.  The amount of capital that they put aside relative to the size of the loan is based on the riskiness of the loan and is often regulated by some government agency.  When a bank buys a bond it is essentially making a loan.  In Europe many of the banks bought bonds issued by the various European governments.  At the time the European regulators did not require the banks to set aside any capital to protect from losses on those loans.  Furthermore, the yields on bonds of countries within the European Union did not differ substantially from one another because investors felt that the fiscal restraints that the Union placed on each member country would keep their creditworthiness sound.

These situations caused no problems as the European (and world) economies were growing up until early 2008.  However, as the U.S. banking problem started to spread throughout the world and caused a global recession, these flaws in the European Union began to crack.  Why?  Well, in Ireland and Spain demand for housing started to dry up and housing prices began to recede.  At the same time unemployment began to rise and mortgage defaults began to increase.  In Ireland the federal government bailed out their banks, ballooning their own national debt.  Spain’s problem is somewhat more subdued than Ireland’s but they are in the process of propping up some banks and liquidating others.  As the recession hit Greece, Italy and Portugal, tax revenues began to fall and demands on government resources such as unemployment insurance began to rise.  The increases in national debt levels have been devastating. 

Normally, a country with such a high level of debt can address the problem in two ways.  The first is to devalue its currency.  The benefit of this action is that it reduces the cost of the county’s exports, making its products more competitive and thus boosting its economy.  Likewise it makes imports more expensive, thereby reducing the demand for imports and improving the domestic demand for its own products.  All of this improves economic growth, and hopefully, increases tax revenues.  This all sounds fine in theory.  In practice it is not quite that easy and in the case of the problem countries of Europe it is impossible since they are using the euro and have no control of their own currency value.
The other action a government can take is to default on its debt.  As this problem has unfolded since 2008, it has become increasingly apparent that the only option for some of these countries, particularly Greece, is to default on its sovereign debt.  As a result, some of the major banks throughout Europe that held this debt became increasingly less stable.  Recall that these banks had come through the 2008 experience somewhat weaker just as the U.S. banks did and needed time to rebuild their financial strength.  That rebuilding period has not fully taken place, so this crisis is hitting fragile institutions.

Without the problem of the banks, Greece would not be an egregious problem for the Europeans.  The Greek economy is only about 2% of the European economy.  But the banks make it a much larger problem, particularly since many of the larger European governments worry that if Greece defaults, some of the other shaky countries may also decide to default.

The situation began to look like the U.S. debt ceiling crisis, with the European governments dithering about what to do and dragging their feet about taking any action to solve the problem.  There are really only three possible courses they can take.  The first is to do nothing, an unlikely course since some countries would likely default, causing the banks to default, badly damaging the entire European economy.  The second possibility is to let at least Greece default and provide aid to the banks to limit the effect on other economies.  While that might prove to be a lesson to countries that allow their debt to get too high, it certainly would be a stain on the European Union.  Thus we are left with the third option which is to provide direct support to the weaker European countries.  That is what is being worked on right now and it appears increasingly likely that the structure for that solution is going to be in place in the next few weeks.

It is the dithering and the fear that the crisis would turn into a pan-European economic crisis that has caused the problem in the international equity markets.  Now it is the optimism that the support structure is about to be put in place that has allowed the financial markets throughout the world to begin to slowly rise during these first few days of October.
With that all said, here’s the scorecard of the best and worst performers for the quarter.

You can see from this chart that the Europeans dominate the bottom of the list.  Russia made an appearance in the bottom most likely because one of the consequences of the fear in the markets is that commodity prices, including oil, fell too.  The energy industry is a major part of the Russian economy, thus the link to the Russian stock market.
On the plus side, Peru was a surprise as their newly elected president, who had a history of Hugo Chavez type rhetoric, initially seems to be holding to his current promises to be more oriented to free markets.  Japan benefited from the strength of their currency; the yen was up 4.4% versus the dollar during the quarter.  In fact, the yen was one of only 3 currencies that appreciated against the dollar during the quarter, which in part helps to explain the dismal performance of the international index as a whole.

Looking to the future, we expect the current halting improvement in the markets to continue.  There is too much at stake for the Europeans if they did not continue putting together their rescue plan.  Consequently it is more than likely to continue, allowing the markets to heal.  The best performance will probably be in the Asian countries, as they continue to directly avoid the American malaise and the European doldrums.  China is the question mark for Asia as it needs to slow its inflation and continue shifting from a heavy export orientation to more domestic consumer consumption, all the while maintaining a growth rate that keeps the lid on dissatisfaction among its citizens.  So the world is in the middle of a difficult balancing act, but isn’t it always?

Eurozone Concerns Generate Domestic Market Volatility

Fear in the eurozone over the spreading European debt crisis came back into the forefront during the third quarter, and equities across the globe experienced a heavy and relentless wave of selling pressure.  With the experience of the 2008 financial crisis and economic recession still relatively fresh in the minds of investors, the growing sovereign debt concerns and liquidity issues of several large global financial institutions gave traders and investors a reason to want to run and not walk for the exit doors.  As a consequence, market volatility spiked to elevated levels, and there were numerous days in August that saw stocks declining or advancing by more than 4% in a single trading session.  The weakest equity results were experienced by the small capitalization companies and international equities, with the Russell 2000 losing 21.9%, while the MSCI EAFE retreated by 18.9%.  The larger capitalization indexes were hit with slightly less force, as the S&P 500 declined by 13.9%, while the NASDAQ slipped 12.7%, and the Dow Jones Industrial Average lost 11.5%.

As a result, beginning on July 21, 2011, the rally that got underway in August 2010 came to an abrupt halt, and each of the equities indexes that we track in our monthly and quarterly MMU gave up all of their year-to-date gains.  As a result, for the first nine months of the year the best result came from the Dow Jones Industrial Average which was off only 3.9%, while the NASDAQ and S&P 500 were quite close at -8.3% and -8.7% respectively.  The MSCI EAFE index and the Russell 2000 delivered returns that were almost twice as negative at -14.6% and -17% respectively.

Only three of the ten S& P 500 sectors — Consumer Staples, Health Care, and Utilities — have delivered positive returns through the third quarter.  Their common attribute is that their businesses are generally more defensive in nature.  In addition to the three sectors with positive absolute year-to-date performance, three other sectors turned in positive relative performance, as the Consumer Discretionary, Telecommunications, and Technology sectors all declined less than had the S& P 500 so far in 2011.  On the other hand, four of the more economically sensitive sectors have, not surprisingly, underperformed the S&P 500’s 8.7% decline.  Specifically, Energy declined by 11.4%, and Industrials dropped by 14.7%, with Materials slipping by 21.7%, while the Financial sector went back to behaving like it did back in 2008, dropping 25.1% during the first three quarters of 2011.

Global GDP growth in this recovery is being held back by a variety of forces, with weak housing activity in the U.S. a noteworthy issue since housing and its related supporting industries are normally a strong driver of economic growth and job creation.  GDP in Europe is slowing to the sub 1% level, and the high savings rates in the eurozone do not allow for the same level of consumer activity that is the case in the U.S.  Specifically, in the U.S. the saving rate of personal disposable income is around 5% (up from very low levels several years ago) versus 13.6% in Europe and 17% in Germany.

After the horrendous experience of the credit crisis in 2008 and 2009, corporate America has made a concerted effort to shore up their balance sheets.  This has been accomplished by raising equity capital as well as by paying down debt and accumulating cash reserves, so as to not be dependent on and at the mercy of the credit markets should they again seize up and become dysfunctional.  In fact the Federal Reserve estimated that at June 30, 2011 cash hoards of U.S. nonfinancial corporations are at an all time high, $2.05 trillion dollars.  The largest percentage of this total is held by technology companies, with an estimated $388 billion, and Apple Computer has close to 20% of this amount with its $76+ billion of reserves. Some of this cash is held in foreign subsidiaries of U.S. corporations and thus can not be brought back into the U.S. unless additional U.S. federal income taxes are paid, which many companies are loathe to do since they have already paid income taxes to the local country where the foreign subsidiary is located.  There is talk in the Congress of passing some sort of tax plan that would encourage companies to repatriate some of this stranded capital back to the U.S. as a way to spur investment and job creation.  With the unemployment level stuck at a stubbornly high level of 9.1%, the U.S. economy has only regenerated 20% of the 8.8 million jobs lost during the credit crisis.  Just to keep up with population growth, the U.S. needs to add at least 150,000 jobs monthly.  Small businesses that are the engine of U.S. job creation have not had the confidence to hire this cycle as they have coming out of prior recessions.

Rates Likely to Remain Low As Debt Circus Continues

When we last wrote this newsletter, we were waiting for the end of the circus in Washington to play out to see what happened to the debt ceiling.  The circus continues but we are past the initial debt ceiling act.  As you may recall, the debt ceiling was raised, there were no defaults and all the hard budget choices were left in the hands of a committee to iron out in the future.  Standard & Poor’s had enough and downgraded the U.S. to AA+.  Moody’s and Fitch both confirmed our AAA ratings.  At the same time, the budgetary crisis in Europe was in the headlines again.  Concerns about the eurozone bailing out one or more of their member countries, costs to other stakeholders, strength of their banks and control going forward are all concerns to the market.  These negotiations have been going on for more than a year now.  As the sentiment about progress in Europe turned negative, money flowed to the U.S., rates declined and people wondered if the S&P ratings downgrade meant anything.  For the moment the U.S. is on the good side of the sovereign debt default discussions.  However, markets are fickle and once they decide the risks in Europe have subsided then we could be in the cross hairs.  The takeaway is that we have too much debt, we continue to run large deficits and without some positive budgetary action we will have a crisis similar to Europe’s.

Over the past few weeks, the Federal Reserve (Fed) started “Operation Twist.”  The Fed’s last program was Quantitative Easing 2 or QE2.  It ended during August of this year and propped up asset prices.  Operation Twist is a program designed to bring down long term rates.  There are two aspects to this program.  First, they will reinvest the cash flow from their current portfolio into mortgage-backed securities.  This will help keep mortgage rates low.  Second, the Fed will sell some of its short term investments and use the proceeds to buy longer term treasuries.  It is estimated that the Fed might buy up to 90% of the longer bonds issued by the Treasury over the next year.  These purchases should act to hold long term rates down. 

There are always consequences to programs like Operation Twist.  For instance, once QE2 was announced, some rates and commodity prices increased.  Talk of deflation ceased and there was some increase in inflation.  We as consumers had to put up with higher gasoline prices for year partly due to this program.  With Operation Twist there are a number of results we are likely to see.  Mortgage rates will continue to be held down.  It is a good time to be a borrower if you have good credit, some home equity and the patience to go through all the regulatory mandated hurdles to get a mortgage loan.  Holding rates low and allowing consumers to refinance leaves them with more cash to spend which may help the economy.  However, savers or those who live off the interest on their investments will continue to be hurt as savings rates and bond yields remain very low.  Some community banks are likely to have problems with rates held so low.  New loans will yield between 3 and 4.5%.  Yet some branch networks cost 3% or more to run.  It does not leave much room to pay interest or take any loan losses.  The government is a winner here as the low rates keep the interest cost of our borrowing to fund the deficit low.

The other main focus of the bond market these days is the economy.  Many economists say that the odds have gone from under 25% earlier this year to over 50% now that we may move into a recession in the near future.  Even if we do not move into a recession, it may feel like one given that growth is likely to be pretty slow for a number of quarters.  Consumer sentiment and business confidence is low enough that spending by either is not going to increase economic activity significantly.   Unemployment is not going to come down quickly with or without the passage of the “jobs” bill.  Temporary jobs and tax cuts funded with permanent tax increases do not boost the economy in a way that causes businesses to expand and hire workers.  With this weakness in the economy likely to be with us for some time, the market is anticipating rates will stay low within a trading range for a period of time.