Fed "Twist" Threatens Long-Term Stock Returns & Retirement Lifestyles

By Daniel R. Amerman, CFA

Below is the 2nd half of this article, and it begins where the 1st half which is carried on other websites left off.  If you would prefer to read (or link) the article in single page form, the private one page version for subscribers can be found here:

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"Collateral Damage" For State And Local Government Finances

Falling interest rates and falling stock values also hit state and local governments hard even as they struggle in the current financial circumstances. These governments have hugely expensive pension obligations, indeed the pension fund promises are so large that they threaten to lead to insolvency for California and a number of states. Already in desperate trouble because of tax revenues that have been reduced by the ongoing depression / recession, this is a time when these governmental units most need earnings from their pension funds - but the floor continues to drop out from beneath their pension funds.

The state and local governments face the challenge of very little income from their bond portfolios. Their stocks drop in value along with the rest of the market, which increases the damage to the pension funds. Meanwhile, their tax revenues drop as retiree investors have less interest income and stock capital gains to declare, which reduces income taxes.  There is a second and also quite significant category of reduction in tax revenues as most retirees cut back on their spending, which in turn reduces the crucial sales taxes element, along with knocking down employment levels.

Therefore state and local governments must cut their own spending, which further slashes corporate earnings growth rates, and further reduces the value of stocks held in public pension funds, in yet another negative loop that interacts with the retiree and corporate pension loops previously discussed.

The Dual Edges Of Financial Repression

The absolute control of interest rates that is the goal of Operation Twist, is a control that is independent of investor desires and such technicalities as the real rate of inflation.  This separation of interest rates from free market forces is absolutely essential for the federal government if it is to meet its goal of avoiding hyperinflation or default via Financial Repression. I will not repeat the extensive discussions of Financial Repression that have occurred in my previous articles (linked below) other than to say that Financial Repression is the academic term for how the developed governments of the world paid down massive debt burdens – comparable to those massive burdens of today – after World War II, without defaulting on their bonds.

The core of Financial Repression is taking money from savers by keeping interest rates below the rate of inflation and slowly squeezing the life from investors' portfolios even as (in inflation-adjusted terms) the value of the government's debts is inflated away. This is the essential element in what the US government is currently doing, it has been with us for a number of years now in its modern manifestation, and if you are not familiar with the particulars, I would strongly urge you to read my article "Financial Repression: A Sheep Shearing Instruction Manual", available at the link below:

http://danielamerman.com/articles/2011/RepressionA.htm

As discussed recently in another of my articles, "The 2nd Edge Of Modern Financial Repression:  Manipulating Inflation Indexes To Steal From Retirees & Public Workers", there is another element of Financial Repression that is systematically reducing the standard of living for tens of millions of people, albeit with comparatively little public discussion. A major difference between the present situation and post-World War II is that most of the US government's spending and impossible promises still lie in the future, as ever increasing waves of Boomers continue to reach retirement age.

For Financial Repression to work this time around, the Social Security beneficiaries as well as the many workers who rely on cost-of-living adjustments to keep up with inflation, must be systematically cheated out of their inflation indexing promises as well. For a thorough analysis of this second edge, follow the link below:

http://danielamerman.com/articles/2011/DoubleRc.html

When we combine both elements of Financial Repression with the stock and pension implications already discussed, we have:

1) Social Security and pension promises that as a deliberate result of government policy do not keep up with inflation;

2) interest income for retirees and retirement investors that as a deliberate result of government policy does not keep up with inflation, and

3) a reduction in consumer spending from 1 & 2 above that then slashes the value of stocks in retirement investment portfolios, with the far reaching effects on corporations and state & local governments. 

Desperately scrambling to deal with soaring debts and impossible promises, the Federal Reserve and US government have chosen a rout of effectively declaring war on retirees, which may trigger potentially catastrophic side-effects for stock market investors in general, and pension funds in particular. 

Reversing The Twist For Personal Wealth

The essence of "Operation Twist", in combination with other Federal Reserve policies, is a "twisting" of the entire US investment markets and economy to serve the interests of the Federal government.  The US government is the largest debtor in the world, owing over $14 trillion in debt, and running annual budget deficits equal to about 10% of the national economy. 

If interest rates go up - the deficit explodes.  If the government keeps a lid on interest rates - regardless of the damage to savers, pension funds and retirees - then it holds the deficit down. 

If interest rates soar, then it could be game over for both the deficit and the value of the US dollar.  On the other hand, if interest rates can be kept below the rate of inflation, along with indexed payments to retirees and public workers - then the US government has a way out after all, via the historically proven tool of Financial Repression, the same tool that worked the last time US government debt levels were this high.  Financial Repression is a path that dodges both default and hyperinflation for the government, albeit at a cost of confiscating wealth from investors and retirees on a hidden basis over a period of decades.

So above all else - the US government is committed to keeping a lid on interest rates.

The US government may or may not succeed, there are numerous problems in this troubled world, and there are several of sufficient magnitude to potentially overwhelm the defenses the US and other nations are erecting.  As one example, a meltdown of the Euro and European economy could flash across the Atlantic and slam into the US economy like a three hundred foot tsunami, making 2008 look like a walk in the park in comparison.  This would likely set off frantic monetization - a straight-up creation of US dollars out of thin air at a fantastic pace, in an attempt to avert disaster.  Creating new money can't substitute for a real economy however, and this predictable response could merely end up assuring the destruction of the dollar and savings and leave the Boomers heading into a historic depression with no jobs and no savings, even as they reach retirement age.

It could happen.  Or it might not.  The bottom line is that the future is fully in play.  While currency meltdown may look inevitable to some, the fact is that a sufficiently motivated government which has full control of all the rules, all the laws and has unlimited monetary creation ability is a far more dangerous and powerful entity than many people understand.

It is also crucially important to understand that a "win" for the government is not a win for retirees and investors.  The government "wins" by crushing the wealth out of the investment markets and the value of investor portfolios.  The government "wins" by "cheating" on inflation indexes, year after year after year, with retirees and public workers facing a steady and grinding impoverishment.

The point of Financial Repression is to leave people with no path out.  Set up the laws and the playing field so that tens of millions of people are steadily impoverished - and the government survives.

There is a way out for individual investors, however, and that is to Reverse The Twist.

Low interest rates can be a gift, instead of a source of impoverishment. 

Low interest rates when combined with a high rate of inflation can be a double source of impoverishment, or they can be a double gift. 

Low interest rates, high inflation, and a government determined to maintain both over the long term can be a worst case scenario that nearly guarantees long impoverishment with no way out - or that same 1-2-3 combination can be a triple gift. 

The difference between guaranteed impoverishment and a triple gift is a matter of gaining knowledge first, and taking action to change your financial profile.

To "Reverse The Twist" and succeed when everyone around you is being impoverished requires turning your perspective upside down, and reversing your financial profile.  The necessary and irreplaceable first step is education.