STOCK MARKET WATCH -- Thursday, 28 June 2012

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49. Federal Reserve runs out of options

http://www.guardian.co.uk/business/economics-blog/2012/jun/27/federal-reserve-runs-out-of-options

The United States Federal Reserve's recent announcement that it will extend its "Operation Twist" by buying an additional $267bn (£171bn) of long-term Treasury bonds over the next six months — to reach a total of $667bn this year — had virtually no impact on either interest rates or equity prices. The market's lack of response was an important indicator that monetary easing is no longer a useful tool for increasing economic activity.

The Fed has repeatedly said that it will do whatever it can to stimulate growth. This led to a plan to keep short-term interest rates near zero until late 2014, as well as to massive quantitative easing, followed by Operation Twist, in which the Fed substitutes short-term Treasuries for long-term bonds.

These policies did succeed in lowering long-term interest rates. The yield on 10-year Treasuries is now 1.6%, down from 3.4% at the start of 2011. Although it is difficult to know how much of this decline reflected higher demand for Treasury bonds from risk-averse global investors, the Fed's policies undoubtedly deserve some of the credit. The lower long-term interest rates contributed to the small 4% rise in the S&P 500 share-price index over the same period.

The Fed is unlikely to be able to reduce long-term rates any further. Their level is now so low that many investors rightly fear that we are looking at a bubble in bond and stock prices. The result could be a substantial market-driven rise in long-term rates that the Fed would be unable to prevent. A shift in foreign investors' portfolio preferences away from long-term bonds could easily trigger such a run-up in rates.