Fed "Twist" Threatens Long-Term Stock Returns & Retirement Lifestyles
By Daniel R. Amerman, CFA
Overview
The Federal Reserve's "Operation Twist" represents a $400 billion assault on retirement investment portfolios, pension funds, corporate stock valuations and the financial viability of state and local governments. As explored herein, the full potential effects of Operation Twist and related Federal Reserve policies include:
1) Reducing the standard of living for tens of millions of current and future retirees;
2) Reducing long-term earnings growth rates for stocks, with a potentially major and long-term reduction in fundamental stock values;
3) Setting off feedback loops that will further reduce both retiree lifestyles and stock valuations; and
4) Increasing the chances of insolvency for state and local governments, as well as many major corporations.
The Fed's announcement that they will be selling $400 billion of short-term treasuries in order to buy $400 billion in long-term treasuries is not the confusing or ineffective obscurity many observers mistakenly believe it to be, but rather it is a textbook example of the strategy of Financial Repression that the US government has chosen in an attempt to avoid either hyperinflation or default. Succinctly put, the key is to take the massive financial pain that would otherwise be forced on the federal government, and instead move the burden elsewhere.
Because the government shortfalls are in the tens of trillions of dollars over the coming decades, only a huge target would be able to bear this burden, and such a target has indeed been found: retirement investors, pension beneficiaries and Social Security recipients. The damage from this deliberate targeting of retiree lifestyles and retirement investors will not be confined to older Americans, however, but in combination with related Federal Reserve actions, will ripple out through the entire US economy, the investment markets, and the world economy as well.
The US government may or may not succeed in dodging default or an abrupt collapse in the value of the dollar. But a vigorous attempt is being made right now in real time, and "Operation Twist" is front and center. This attempt and related actions may very well dominate the retirement and long-term investment world for years or decades, albeit beneath the surface.
In this article we will pull the mask back from what the government is doing, expose the multiple layers of danger for retirement investors, the directly related and potentially catastrophic risks for stock investors, and how this endangers both corporations and state and local governments. We will also discuss how investors can "Reverse The Twist" for their own protection.
The Federal Reserve's Attack On Retirement Investors
By announcing its intention to sell Treasuries with maturity of less than three years, and invest the $400 billion generated to buy Treasuries with maturities of over 10 years, the Federal Reserve is successfully driving long term borrowing costs for the US treasury to record lows. According to Oppenheimer (via Reuters), by the time of the widely anticipated announcement, 10-year US Treasury yields were 0.40% below their previous 60 year low, and almost 2% below the average of the previous five years.
There is no longer any pretense of a free market when it comes to interest rates, but rather the Federal Reserve has taken near complete control of short term, medium term and long term interest rates.
The effects of this go far beyond federal government borrowing costs. Generally speaking, nearly all interest rates in the United States are based upon the "risk–free" yield for a particular term, which generally means Treasury yields (S&P downgrades notwithstanding), with a spread then added on top of that base interest rate. So when the Fed moves Treasury interest rates down to record lows, it means that many forms of bonds and fixed-income instruments which are based on Treasuries generally move down as well, whether they are money market funds, Bank CDs, corporate bonds, municipal bonds, or fixed-rate annuities.
What this means from a retirement investor and retiree perspective is that there simply aren't good interest rates available anywhere, at least not on a risk-adjusted basis. Conventional retirement investment theory calls for investors to have a heavy weighting in fixed income investments after retirement, and what Operation Twist does is to further reduce income from those investments for retirees.
Traditionally speaking, retirement investments are built on a twin base of bonds and stocks. The stock market as measured by the Dow Jones Industrial Average reacted to Operation Twist by falling 500 points in the immediate aftermath. So retirement investors took a major double hit – less money for their stocks and reduced income from their bonds.
Consumer prices have meanwhile climbed substantially in recent years, and at an annual effective rate that is well in excess of the return that can be earned on government bonds (the official inflation indexes notwithstanding). So retirees find themselves in a situation where the cost of utilities is climbing, the cost of food is climbing, the cost of clothing is climbing and so are the property taxes from their state and local governments. When it comes to monthly budgets, there are multiple major categories of expenditures that are ratcheting up, even as investment income and cost of living adjustments fall to near zero.
As a retiree, there's effectively only two ways of dealing with that situation. Either you increase the rate at which you spend down your savings, meaning you risk running out of money much faster than you've been planning, or else you have to slash your current spending and take the major standard of living hit that comes with that - with either predicament being a quite direct result of the Federal Reserve's very intentional and calculated "Operation Twist".
It is also essential to keep in mind that the Federal Reserve is not doing this on a temporary basis, but rather has assured the markets that it plans to keep it in place for a good long time, at least until the year 2013. Which means that as a result of government policy, retirees and retirement investors have (effectively) been told that they can expect almost no income from their fixed income investments for the next two years, even as they scramble to try to cope with increasing prices for the necessities of life.
Potentially Catastrophic "Collateral Damage" Upon Corporate Earnings Growth & Stock Values
If there is going to be virtually no income from bonds, this leaves only stocks for retirees and traditional retirement investors to fall back upon as a source of income. Unfortunately, there is a very direct and negative long term effect on stock values that flows from Operation Twist and other long-standing federal government manipulations that have resulted in historically low interest rate levels.
It is not only retirees who have less money to spend; this will also have a direct impact on those who are saving for retirement, particularly those in their last 10 or 15 years before planned retirement. If these middle-aged investors are going to maintain their expectations for the age at which they retire, and also be able to afford the lifestyle they have planned for in retirement - while sticking to conventional approaches - they can only do so by increasing their retirement investment purchases right now.
For any given future standard of living, if investment rates go down, the way to make up the difference is to put more in right now. So we are talking not just about tens of millions of current retirees, but also tens of millions of others who are currently privately saving for retirement, with both groups having less money to spend because of very low interest rates.
This reduction in spending by tens of millions if of course crucial because consumer spending accounts for about 70% of the US economy. And more than any other factor, it is consumer spending that determines corporate earnings. Corporate stock values are based not just on earnings from current consumer spending, but even more importantly, upon expectations of increases in corporate earnings that result from future increases in consumer spending.
This distinction between current earnings and expectations of future earnings may sound a bit technical if you aren't a financial analyst, but it is far from a technicality, for expectations about future earnings are the source of most of the value in the stock market. At current dividend levels one can't justify buying stocks – not for the reasonable income expectations most people have for stocks – unless there is a strong growth component where we can expect corporate earnings to rise in each coming year.
However, if we simultaneously have tens of millions of retirees spending less each year because they have almost no interest income, along with tens of millions of middle-aged people in their peak earning years having to cut back on spending in order to put more money into their retirement savings – then we have a double drag on consumer spending which means that zero growth in spending might be a best case scenario, with declining consumer spending being the more likely result.
Either flat consumer spending or declining consumer spending are both essentially fatal for current stock market valuation levels, and the longer these conditions persist, the more likely that there will be a fundamentals-driven long term bear market in stocks. And when we combine virtually zero income from bonds with falling stock market values, then we have no source of investment income at all for current retirees who follow traditional retirement investment strategies, and we have no source of compounding for conventional retirement investors.
This is an issue that has been coming for a very long time – even without including current Federal Reserve actions or the financial crisis. As I have been writing for many years, one of the "Six Fundamental Flaws" inside of conventional financial planning is that everyone has been told to purchase investments based on a (necessarily implicit) assumption of unending growth in consumer spending - without considering what happens when the wave of Baby Boom retirement begins to hit and then builds each year.
Retirement is a time of life that is usually associated with decreasing consumer spending. Therefore stocks as a retirement investment have always carried their own built-in "fuel cutoff valve", for the reason that just at the time when a building wave of Boomer retiree investors will most need income from selling their stocks, there will be a larger building wave of Boomer retirees (including non-investors) who will be dropping their spending in retirement.
This will predictably drive a reduction in the growth rate in consumer spending, which will then predictably reduce the fundamental value of stocks. This negative loop then continues to build in each following year as ever more Boomers enter retirement and begin selling stocks which rely on unending growth in consumer spending, even while simultaneously further reducing their own consumer spending rates.
The above is a very condensed form of "Logic Flaw #3" from my website resource "Six Fundamental Logic Flaws In The Heart Of Conventional Financial Planning." The link below contains a much more detailed description of this issue and its interrelationships with the other five fundamental Logic Flaws.
http://danielamerman.com/bOne.html
This long-standing fundamental Logic Flaw has already been made much worse by the economic crisis and by high rates of unemployment that have been knocking consumer spending down across the board. There has already been a deadly effect on stock values as more and more of the economy is consumed by government spending, with less and less room for the private sector growth which determines stock market values. A much more thorough analysis of this issue can be found in my article "Soaring Government Spending 'Crowds Out' Private Investment Returns", linked below.
http://danielamerman.com/articles/Crowding.htm
To understand just how disastrous "Operation Twist" could be for stock market values, we have to take into account the cumulative and interwoven nature of the reductions in consumer spending:
1. Even in a "normal" economy, an increasing percentage of the population being in their retirement years fundamentally reduces the growth rate in consumer spending, which reduces stock valuations;
2. The economy is in terrible shape, and the private sector has never recovered from 2008, which is profoundly negative for consumer spending growth and stock valuations;
3. These two powerful negative factors are being aggravated by the Federal Reserve deliberately reducing the interest income available to retirees, which adds another layer of reduction in consumer spending;
4. This then sets up a loop, as lower stock values compound the damage from the near complete lack of income from bond investments, meaning retiree investors must radically reduce expenses and their standard of living, which means spending less, which further reduces stock values, which further reduces standard of living, and so forth.
The Pension Feedback Loop
Unfortunately - and making matters worse - there is another feedback loop in play when it comes to corporate pensions and corporate earnings.
The less interest income that is available for pensions, the more trouble they have in keeping up with their long term investment goals. Much like individual conventional financial planning, pension investments by corporations have effectively been based on the assumption that we knew the future, and it was a good one, in which wealth properly invested would reliably compound, with only a manageable and moderate amount of risk over the long term. This has been a profoundly mistaken assumption the entire time and not mathematically supported by investment history, as I have been writing about for almost twenty years (Logic Flaws #1 & #2 from the previously linked "Six Fundamental Logic Flaws" resource).
Nonetheless, it has been the prevailing paradigm. Therefore the corporations have funded pensions with relatively little money compared to the benefits they promised to pay out in the distant future, and they have relied upon assurances of a supposedly near-guaranteed compounding of wealth from stocks and bonds to deliver the difference. Corporations never did have the money to meet pension promises they had made to workers - indeed, that was the whole point of pensions. The "magic" of compounding wealth through the markets was supposed to do the heavy lifting and deliver most of the money promised to retirees, so it wouldn't have to come out of future corporate earnings.
The availability of these "defined benefit" pension plans has become ancient history for most employees today, having been replaced by 401(k)s and the like, yet so many legally binding promises were made to so many workers that these pensions are in many cases the "tail that wags the dog" when it comes to the major legacy corporations such as IBM, or GM & Chrysler prior to government takeover. That is, pension investment performance can be more important to earnings than total corporate operating income over the long term (although the short-term market effects are smoothed out with the special accounting used for pensions).
The effect upon stock prices of the Federal Reserve's "Operation Twist" and other efforts to suppress interest rates can best be understood within the context of the following relationships:
1) Many corporate and public pension funds are already feeling severe pain, because the supposedly reliable magic of the markets compounding wealth hasn't been there for the pensions for a solid decade now;
2) when the Fed forces long term interest rates to historic lows, it is essentially a "kicking a man when he is already down" situation, as this further reduces pension earnings, which raises the contributions that individual corporations must make to their pension funds in order to stay fully funded, which reduces individual corporate earnings;
3) this individual pension investment-induced squeeze is happening at the same time that corporate earnings and their growth rates are being hit by falling consumer spending, as discussed in the previous section;
4) the combined 1-2 punch of an earnings squeeze from two directions drops the value of many individual companies;
5) because the individual company pension funds are invested in each other's stocks, each feels the other's pain as each of their pension plan investment values are hurt by the decline in other corporation's stocks;
6) this then requires each company to further increase pension contributions, which further reduces numerous individual corporate earnings, which then loops back to further reductions in stock values; and
7) the above feedback loop is happening simultaneously with the retirement income and spending feedback loop previously described, with the two loops then feeding upon each other.
"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.
