Flattening Yields and the Federal Reserve's Great Folly

There is no doubt that the global economy now resides in uncharted monetary policy territory.  With the Federal Reserve and other key central banks holding fast to their ultra-low interest rate policies, we really have no idea how the economy will react when interest rates begin to rise.  One thing that we do know about the impact of the zero interest rate policy is that it has forced "Mom and Pop" investors to take on additional risk with their modest retirement portfolios if they hope to have any chance of retiring with more than a cat food future.  For decades, small retail investors who were saving for retirement usually invested in either government bonds (i.e. Treasuries) and investment-grade corporate bonds.  Unfortunately, this is what has happened to the yield on ten year Treasuries:

At 2.26 percent, one would have to have very, very substantial savings to generate enough income for retirement.  As we will see in this posting, in the current ZIRP environment, caution has been thrown to the wind along with the possibility of having significant balances in retirement accounts should the stock market begin to reflect actual valuations once the Federal Reserve turns off the "monetary taps".

A  recent analysis by Fidelity looks at America's 401(k) and IRA accounts.  Let's start out by looking at some background data first:

Average 401(k) balance end of Q2 2015 - $91,100

Average 401(k) balance end of Q1 2015 - $91,800

Average IRA balance end of Q2 2015 - $96,300

Average IRA balance end of Q1 2015 - $94,000

Over the past five years, the average 401(k) balance has risen by 50 percent with much of the gains related to a rising stock market which has resulted in an increased percentage of equities held within 401(k)s.  This could prove to be problematic; the analysis notes the following:

1.) 18 percent of people between 50 and 54 years of age had a stock allocation in their 401(k)s that was 10 percentage points or higher than the recommended level based on their age.

2.) 27 percent of people between 55 and 59 years of age had a stock allocation in their 401(k)s that was 10 percentage points or higher than the recommended level based on their age.

3.) an additional 11 percent of people between 50 and 54 years of age had 100 percent of their 401(k) assets in stocks.

4.) an additional 10 percent of people between 55 and 59 years of age had 100 percent of their 401(k) assets in stocks.   

As many of us learned in 2008 - 2009, having a substantial exposure to equities can be a painful experience.  Losses on equities can take years to recover and, in some cases, recovery never happens. What often happens is that retail investors sell their equity assets as the price drops, trying to minimize losses and then transfer the cash into a more secure asset like United States Treasuries.  Here's where the Federal Reserve enters the equation.

As the Fed has been telegraphing, it is planning to raise interest rates and has teased us for the past few months about the timing of the liftoff.  As we can see from this yield curve showing the yield on ten year Treasuries, so far, other than a bit of a spike in mid-2013, the bond market has pretty much discounted any significant change in interest rates:

Once the Fed does being to raise rates, investors, particularly those who have an "overallocation" of equities (and high yield corporate junk bonds as well), will most likely begin to reallocate their portfolios into more age-appropriate risk profiles.  With the information on inappropriate levels of equities held by older Americans that the Fidelity analysis outlined, Michael Thompson at S&P Capital IQ estimates that roughly $1.3 trillion in retiree assets are misallocated into equities when based on the 16-year average price-to-earnings ratio for the S&P 500.  As ZIRP fades and interest rates rise, funds will flow into Treasuries, creating a supply-demand imbalance (too much demand, not enough supply).  Since bond yields move inversely to bond prices, as demand rises, Treasury prices will rise and yields will be pushed back down.  What this means is that the yield curve will flatten rather than rise as the Federal Reserve expects.  Mr. Thompson estimates that the overnight federal funds rate will have to rise to about 3 percent (it is currently at 0.25 percent) before the supply-demand imbalance for Treasuries is normalized, a process that is likely to take several years. 

Historically speaking, the Federal Reserve has had fairly tight control over the yield curve, manipulating it as it saw fit to either slow down an overheated economy or speed up an underachieving economy.  As I said in the opening paragraph, we are now living in uncharted monetary policy territory.  The unintended consequences of the Fed's long experiment with zero interest rates keep piling up and Americans who are saving for their retirement are likely to be yet another in a long line of victims.

The Federal Reserve's Great Folly indeed.