Wondering why the stock market's reaction to the Federal Reserve's Operation Twist – buying longer-term bonds and selling short-term bonds – has been so negative? Let's call it economic capitulation: The point at which the last optimistic impulse over the European debt crisis, U.S. economic growth and the ability of central banks to do much of anything gives way to hopelessness.
Colin Cieszynski, market analyst at CMC Markets Canada, put it nicely: "The twin realities of a slowing global economy and the unlikelihood of any major new stimulus from governments or central banks appears to finally be sinking in," he said in a note. "Yesterday's 'twist' announcement from the Fed appears to have finally convinced the last dreamers out there that additional stimulus money in the form of QE3 is a dead issue for now and the best the street can hope for from the Fed is some tweaking around the edges."
Meanwhile, Ed Yardeni at Yardeni Research has come up with eight reasons why the market reaction to the Fed has been so severe:
- Mortgage rates tend to move more closely with the 10-year Treasury bond than the 30-year yield, and the yield on the 10-year bond was already at a record low. Yet, housing remains depressed.
- Investors are concerned that the Fed is running out of tools.
- The flattening of the yield curve – which is what Operation Twist is designed to do – is bad news for financials since their net interest margin is getting squeezed hard. Indeed, he believes that the Twist might be counterproductive, in that it will discourage financial institutions from lending.
- Near-zero bond yields are a disaster for individual savers and institutional fixed income investors.
- The Fed is shutting the exit doors it will need for its exit strategy from extremely stimulative monetary policy. When the Fed gets around to tightening monetary policy, its now larger portfolio of longer-term bonds will be hit.
- Despite everything the Fed has done to stimulate the economy, the outlook is deteriorating.
- The Fed isn’t sure how Operation Twist will work to boost the economy. In its FAQ, it said that the effect is difficult to estimate precisely.
- Monetary policy can’t fix all of our problems.