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Tax & Investment Notes is a publication by Scott K. Anderson, Jr. CFP®, CPA, EA and author of Making Sense on the Dollar.
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Tax & Investment Notes
June 2014

"Yes! We Have No Bananas"

“Yes! We Have No Bananas” was a novelty song from the early 1920’s.  There are several claims to its origin but suffice it to say, I was thinking of the recent actions of the Federal Reserve.  Everything that is supposed to be up is now looking down.

In May, I gave two workshops on fixed income investing as part of the financial outreach efforts of the Financial Empowerment and Estate Literacy organization. (feelincontrol.org.)  At my workshops, the takeaways about fixed income investing include the following: 

  1. the price of fixed income investments move in the opposite direction to interest rates moves;
  2. all interest rates follow the Yield Curve, which is a plot of the interest rates on US Treasury securities at various maturities at any point in time; and,
  3. the statistic that a fixed income investor should watch most carefully (aside from credit quality) is duration, which measures the sensitivity of the price of a fixed income investment to changes in interest rates. 
The slides from the second of the presentations (May 29th) can be found on my website: ScottAndersonFinancial.com.

Frankly, I am not sure anyone knows what the Fed is up to.  We are in uncharted waters here. Nonetheless, there are several theories out there.  The theory I believe makes the most sense is propounded by Brian Wesbury of First Trust Portfolios. It goes roughly like this.

Following the 2008 – 2010 market chaos, gentle Ben Bernanke, Chairman of the Federal Reserve Bank, wanted to facilitate the recovery by keeping interest rates low.  Since interest rates move opposite to bond prices, Ben and the Fed invented several programs called Quantitative Easing under which the Fed bought US Treasury securities from banks on the government credit card to the tune of $4 trillion (that’s trillion with a “t”).  The purchases put cash in the banks to lend while creating a low interest rate environment (buying bonds pushes bond prices up which pushes interest rates down).

Well, the banks had seen this movie before. The movie ended badly when the Fed suddenly came in trying to cool an “overheated” economy by selling bonds to banks to contract the availability of cash for banks to lend. This, in turn, forced banks to call (i.e. not renew) business loans outstanding which, in turn, slows economic growth. Today, the bank regulatory agencies add a wild card to the Fed’s efforts by being very aggressive in looking at bank lending and punishing banks for “risky” loans …whatever that means. So the banks are now doing what anyone would do when pushed in two different directions: they stopped all but the safest lending and the recovery such as it has been, has plodded on (The Plough Horse Economy in Wesbury’s words).

In late 2013 with no discernible accomplishment and his term coming to an end, gentle Ben decided to phase out Quantitative Easing and to stop buying bonds from banks. Given all the noble purposes that the Fed had surrounded the Quantitative Easing program with, the market first assumed that without the Fed acting, interest rates would rise.  And rates did rise.  For a while.  But interest rates have started to fall again.

The interest rate on the ten year Treasury note is the bell-weather rate in the marketplace (symbol ^TNX on Yahoo Finance) and has fallen from about 3.5% at the end of 2011 to a low of about 1.5% in mid-2012.  The ten year Treasury rate then slunk along below 2% through the first part of 2013 and gradually increased to about 3% again at the beginning of 2014.  But as the Fed has actually started taking its foot off the bond buying accelerator in 2014, interest rates have started to fall and are now back around the 2.5% mark.

The banks, like everyone else, are still trying to figure out what the Fed is up to. The conventional wisdom held that rates are supposed to go up without the Fed acting, but rates are drifting down—at least for now.  Has all that sturm und drang by the Fed been for nothing?  The reality is that the banks are lending (very carefully) as the economy continues to grow, no more and no less, and not at the allegretto tempo pushed by the Fed. So all the Fed’s cash is sitting in the banks—literally.   

I read the above to my golden retriever Riley to see if she had any comment.  She looked at me and then went and sat by the closet door where her leash is kept.  Probably the best summary of all.  Just keep on keeping on.  Don’t do anything drastic.  Be patient until the opportunity for a walk comes. 

Memorial Day marks the unofficial start of summer and warmer temperatures.  Riley does not like short walks because she hardly gets winded and she does not like long walks because she comes home dragging and exhausted.  She likes those intermediate walks—the Goldilocks walks—not too long and not too short.  Sounds like a good fixed income investment strategy in a heated and risky environment. Not too short where there is minimal return.  Not too long where there is risk if the Fed moves the wrong way. Fixed income investments with a five year or so duration are just about right.  Maybe that is why some people say that dogs see and feel things that we humans cannot.

Scott Anderson

CPA CFP EA   

IRS Circular 230 Disclosure: if this newsletter contains any type of tax advice, please be advised that, based on current IRS rules and standards, the advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty that the IRS may assess related to the matter.

Scott Anderson, CPA, CFP®, EA



Interested in learning more about Scott Anderson's dividend and interest income strategy?

Download the introduction to Chapter 5 and 6 of Scott's book, Making Sense on the Dollar.


 


 
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