Tom Sowanick is Co-President and Chief Investment Officer of Omnivest Group in Princeton, N.J.
The Federal Reserve took an unusual step yesterday in stating that “economic conditions including low rates of utilization and a subdued outlook for inflation over the medium run are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013”.
Investors have taken this statement to mean that Fed will not change its interest rate policy for the next two years.
The initial reaction was to produce a sharp rally in Treasury notes and bonds and pushed global equities sharply higher. While this outcome was welcomed, the overall reaction may have been too much.
Consider the risk to fixed income investors who will be forced further out the yield curve, to as far as the 5-year Treasury note and still earn less than 1 percent yield.
In essence, the Federal Reserve has inadvertently and implicitly extended the maturity of the average money market fund from less than 1 year to up to 5 years.
This risk is far too great.
In reality, the Fed did not guarantee that fed funds would be grounded in a 0 to 0.25 percent until mid-2013. Instead, they used the phrase “exceptionally low levels” which is a relative statement. Relative to where interest rates should be to the economic environment.
In other words, if and when the Fed decided to raise rates, it will do so in deliberate and very slow pace.
The Federal Reserve also said that it “discussed a range of policy tools...and that it was prepared to employ these tools as appropriate”. This statement opens the door for additional quantitative easing. The Fed could extend its Treasury purchases to the back end of the yield curve to push long-term borrowing costs lower.
In addition, the Fed could charge banks a fee for reserves held at the Fed to promote lending.
Until banks and other lending institutions begin to ease their lending restrictions, it is unlikely that lower interest rates alone will promote stronger housing activity or other interest rate sensitive growth.
In the meantime, investors are now forced to extend the average maturity of their fixed income assets to earn incremental yield. However, investors need to remain alert to any change in the direction of interest rates in order to return to shorter
Non-U.S. dollar fixed income assets should be increased for investors to gain significantly higher yields. For example, one-month Mexican deposit rates currently yield 3.13 percent. Investors with a longer term horizon should either add to equity positions or establish new positions.
Equity markets are more than fairly valued and offer superior long-term return prospects in a very low interest rate environment.