Uneasy Money

In yesterday’s (December 27, 2011) Wall Street Journal, Cynthia Lin (“Fed Policy Delivers a Tonic for Stocks”) informs us that the Fed’s Operation Twist program “has been a boon for investors during the year’s final quarter.”

The program, which has its final sale of short-dated debt for the year on Wednesday, pushed up a volatile U.S. stock market over the past few months and helped lower mortgage rates, breathing some life into the otherwise struggling U.S. housing sector, they said. Last week, Freddie Mac showed a variety of loan rates notching or matching record lows; the 30-year fixed rate fell to 3.91%, a record low.

In Operation Twist, the Fed sells short-dated paper and buys longer-dated securities. The program’s aim is to push down longer-term yields making Treasurys less attractive and giving investors more reason to buy riskier bonds and stocks. While share prices have risen considerably since then, Treasury yields have barely budged from their historic lows. Fear about the euro zone has caused an overwhelming number of investors to seek safety in Treasury debt. . . .

The Fed’s stimulus plan is the central bank’s third definitive attempt to aid the U.S.’s patchy economy since 2008. As expectations grew that the Fed would act in the weeks leading up to the bank’s actual announcement, which came Sept. 21, 10-year yields dropped nearly 0.30 percentage point. Since the Fed’s official statement, yields have risen modestly, to 2.026% on Friday, from 1.95% on Sept. 20. Fed Chairman Ben Bernanke said in October that rejiggering the bank’s balance sheet with Operation Twist would bring longer-term rates down 0.20 percentage points.

Sounds as if we should credit Chairman Bernanke with yet another brilliant monetary policy move. There have been so many that it’s getting hard to keep track of all his many successes. Just one little problem. On September 1, around the time that expectations that the Fed would embark on Operation Twist were starting to become widespread, the yield on the 10-year Treasury stood at 2.15% and the S&P 500 closed at 1204.42. Three weeks later on September 22, the 10-year Treasury stood at 1.72%, but the S&P 500, dropped to 1129.56. Well, since then the S&P 500 has bounced back, rising about 10% to 1265.43 at yesterday’s close. But, guess what? So did the yield on the 10-year Treasury, rising to 2.02%. So, the S&P 500 may have been risen since Operation Twist began, but it would be hard to argue that the reason that stocks rose was that the yield on longer-term Treasuries was falling. On the contrary, it seems that stocks rise when yields on long-term Treasuries rise and fall when yields on long-term Treasuries fall.

Regular readers of this blog already know that I have a different explanation for movements in the stock market. As I argued in my paper “The Fisher Effect Under Deflationary Expectations,” movements in asset prices since the spring of 2008 have been dominated by movements (up or down) in inflation expectations. That is very unusual. Aside from tax effects, there is little reason to expect stocks to be affected by inflation expectations, but when expected deflation exceeds the expected yield on real capital, asset holders want to sell their assets to hold cash instead, thereby causing asset prices to crash until some sort of equilibrium between the expected yields on cash and on real assets is restored. Ever since the end of the end of the financial crisis in early 2009, there has been an unstable equilibrium between very low expected inflation and low expected yields on real assets. In this environment small changes in expected inflation cause substantial movements into and out of assets, which is why movements in the S&P 500 have been dominated by changes in expected inflation.  And this unhealthy dependence will not be broken until either expected inflation or the expected yield on real assets increases substantially.

The close relationship between changes in expected inflation (as measured by the breakeven TIPS spread for 10-year Treasuries) and changes in the S&P 500 from September 1 through December 27 is shown in the chart below.

In my paper on the Fisher effect, I estimated a simple regression equation in which the dependent variable was the daily percentage change in the S&P 500 and the independent variables were the daily change in the TIPS yield (an imperfect estimate of the expected yield on real capital), the daily change in the TIPS spread and the percentage change in the dollar/euro exchange rate (higher values signifying a lower exchange value of the dollar, thus providing an additional measure of inflation expectations or possibly a measure of the real exchange rate). Before the spring of 2008, this equation showed almost no explanatory power, from 2008 till the end of 2010, the equation showed remarkable explanatory power in accounting for movements in the S&P 500. My regression results for the various subperiods between January 2003 till the end of 2010 are presented in the paper.

I estimated the same regression for the period from September 1, 2011 to December 27, 2011. The results were startlingly good. With a sample of 79 observations, the adjusted R-squared was .636. The coefficients on both the TIPS and the TIPS spread variables were positive and statistically significant at over a 99.9% level. An increase of .1 in the real interest rate was associated with a 1.2% increase in the S&P and an increase of .1 in expected inflation was associated with a 1.7% increase in the S&P 500. A 1% increase the number of euros per dollar (i.e., a fall in the value of the dollar in terms of euros) was associated with a 0.57% increase in the S&P 500. I also introduced a variable defined as the daily change in the ratio of the yield on a 10-year Treasury to the yield on a 2-year Treasury, calculating this ratio for each day in my sample. Adding the variable to the regression slightly improved the fit of the regression, the adjusted R-squared rising from .636 to .641. However, the coefficient on the variable was positive and not statistically significant. If the supposed rationale of Operation Twist had been responsible for the increase in the S&P 500, the coefficient on this variable would have been negative, not positive. So, contrary to the story in yesterday’s Journal, Operation Twist has almost certainly not been responsible for the rise in stock prices since it was implemented.

Why has the stock market been rising? I’m not sure, but most likely market pessimism about the sway of the inflation hawks on the FOMC was a bit overdone during the summer when the inflation expectations and the S&P 500 both were dropping rapidly. The mere fact that Chairman Bernanke was able to implement Operation Twist may have convinced the market that the three horseman of the apocalypse on the FOMC (Plosser, Kocherlakota, and Fisher) had not gained an absolute veto over monetary policy, so that the doomsday scenario the market may have been anticipating was less likely to be realized than had been feared. I suppose that we should be thankful even for small favors.