Markets

Fed's 'Twist' Pulling Down Bond Yields—Are Stocks Next?

In addition to bringing down long-term interest rates, the Federal Reserve has accomplished something else with its Operation Twist announcement—lowering expectations for growth.

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Investors traditionally look for rates, particularly on the benchmark 10-year Treasury note, for clues about the central bank's economic outlook.

With the 10-year yielding less than 2 percent and the 30-year bond below 3 percent, the message is clear that the Fed does not expect robust growth ahead.

And along with those expectations comes the view from some investors that owning stocks in such a climate isn't a great idea.

"They're just pushing on a string. There's nothing going to happen per se with a ridiculous 30-year and 10-year in terms of rates, except that it's going to force, marginally, some people into dividend stocks," says Michael Cohn, chief market strategist at Global Arena Investment Management in New York. "It's going to be tough for the risk-on trade here for a while."

Under normal circumstances, low yields on bondsare supposed to help stocks as investors tire of poor returns on debt and switch to riskier assets. Indeed, some strategists have advocated holding dividend-paying stocks as the Standard & Poor's 500 yield surpasses the 10-year note.

But with an overload of pessimism already in the market, the Fed's "Twist" announced last week—in which it plans to swap out $400 billion of short-term government debt on its $2.8 trillion balance sheet and buy-longer-duration Treasurys—also has dampened enthusiasm for fundamental economic growth.

The Treasury market is sending the message that inflation, in particular the healthy kind that comes from growth, is dead for now as the central bank commits to a zero-interest rate policy for at least the next two years.

"One source of inflation is a healthy economy running at full tilt and companies exercising pricing power over the consumers of their goods and services," Nicholas Colas, chief market strategist at ConvergEx in New York, wrote in his daily market analysis.

"A 10-year note yielding less than 2 percent signals that Treasury buyers do not think such a scenario will play out until 2021 at the earliest," he continued. "That means little domestic earnings growth through the cycle and even less in the way of a recovery in domestic labor markets. Hard assumptions to justify owning equities, to be sure."

That idea of generating positive inflation has gained prominence recently as forecasts for gross domestic product growth come down and the Fedadvances its idea to drive down borrowing costs from already near-record lows.

Over the weekend, Goldman Sachs economist Sven Jari Stehn released a bold proposal that would entail a joint effort between the Fed and Congress.

Washington, under Stehn's plan, would embark on an aggressive stimulus program using government debt. The Fed then would crank up the printing presses and simply monetize the debt away once growth has reached a desired level.

It's a dangerous plan that risks inflation, particularly when the headline rate is at 3.6 percent and the core rate—stripping out food and energy—is at 1.8 percent, near the Fed's desired range of 2 percent. The controlling of inflation is half of the central bank's dual mandate, so the idea is representative of how desperate the market is of creating growth.

"Combining fiscal stimulus with a change in the Fed’s targeting regime and further purchases of Treasury securities would be a powerful device to enhance the credibility of the Fed’s commitment to push up prices," Stehn wrote in a research note. "Such cooperation would be a radical but highly effective tool: fiscal policy would accumulate additional public debt and the Fed would inflate it away."

While the chance of enacting that type of program is unclear, it is much easier to see how such uncertainty has bred some strange trading patterns.

Stock trading has featured wild seesaws, including rallies in the first two trading days this week that seemed to be built on hopes that a European solution is near. Investors, though, have bet on similar scenarios in the past only to be disappointed.

"Investors right now are behaving schizophrenically. They're responding to every little head fake, taking things they've loved and getting rid of them," says Uri Landesman, president of Platinum Partners in New York. "The smart guys are just picking people off."

Landesman says investors for now ought to trade the market in a range—selling when the S&P 500 gets around the 1260 range and buying around 1120.

Simply "avoiding a recession would be positive for the market right now," he says. "We're a lot closer to the bottom than the top and that's bullish. But it's really valuation. It's not like there's some silver bullet coming."