Turn Cheap Money Into Big Profits

01/04/2013 9:00 am EST


John Mauldin

Chairman, Mauldin Economics

You can't simply throw up your hands and take comfort in small yields and low growth just because cheap money is flooding the planet, notes John Mauldin of Mauldin Economics.

If cheap money is good, then free money must be even better!

Real yields (after inflation) are already negative. The yield on the ten-year Treasury bond is below 1.5%, and three-month rates are 0%. The yield on five-year TIPS is -1.05%! How much lower can it go?

Heaven knows, but the Fed is determined to push rates lower, because that seems to be the first, middle, and last page of the Central Banker Training Manual.

The Federal Open Market Committee (FOMC) of the Federal Reserve decided to extend Operation Twist into 2013 and committed an additional $267 billion. In Operation Twist, the Fed uses cash from the sale of short-dated Treasuries to buy longer-dated securities, in an effort to bring down long-term rates. The hope is that this will reduce the cost of mortgages and auto and business loans.

By the way, as much as I’d like to blame Ben Bernanke for dreaming up Operation Twist, the truth is that a different economic genius came up with it. The original Operation Twist was a program executed jointly by the Federal Reserve and the Kennedy Administration in the early 1960s, to keep short-term rates unchanged and lower long-term rates, thus “twisting” the yield curve. As with today’s version, the notion behind Operation Twist 1 was that lowering long-term rates would encourage housing and business investment.

If Operation Twist phase two doesn’t work (phase one didn’t), the Fed is prepared to do even more: “The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

The further action would likely be another round of quantitative easing. Given the failing health of our economy, it is only a matter of months before the Fed re-cranks up its printing press. Even the Fed is concerned about the slowing US economy—go figure!

What hasn’t gotten a lot of media attention lately is that, in addition to extending the Twist, the Fed also quietly revised its forecasts for the economy at the latest FOMC meeting. At the April FOMC meeting, the Fed forecasted that the US economy would grow by 2.4% to 2.9% in 2012. Now the Fed expects the US to grow by only 1.9% to 2.4% this year.

Expectations for 2013 were also revised lower. The Fed also reduced its GDP forecast from a range of 2.7% to 3.1% down to a range of 2.2% to 2.8%.

Keeping Up with the Bernankes
Ben Bernanke isn’t the only central banker that thinks cheap and/or free money is the solution to all the world’s economic woes. Last summer, the European Central Bank, the People’s Bank of China, the Bank of Korea, and the Central Bank of Brazil all cut their key interest rates:

  • The ECB cut its key lending rate by a quarter of a percentage point to 0.75%, taking it below 1% for the first time in that bank’s history, and cut the deposit rate it pays on overnight funds from 0.25% to zero.
  • The PBoC chopped its one-year deposit rate by 25 basis points to 3%, and its one-year lending rate by 0.31% to 6%.
  • Brazil’s central bank first reduced its 2012 GDP growth forecast from 3.5% to 2.5% and then lowered its key lending rate from 8.5% to 8%, the lowest rate in Brazil’s history.
  • The Bank of Korea did the opposite of Brazil. First it cut its rates for the first time in three years, by a quarter of a percent, and then it lowered its growth forecast from 3.5% to 3%.

Not wanting to feel left out from the global print-a-thon, the Bank of England increased the size of its quantitative easing program by £50 billion ($78.1 billion), bringing the total commitment to £375 billion.


Don’t Be a Yield Minnow, Be a Yield Shark!
Clearly, the world’s central bankers are determined to push yields lower and keep them low until the global economy turns around.

But recovery will take a few years, perhaps even longer. And living under the new global monetary rules, you must invest differently if you want to prosper.

What these central bankers are doing is defrauding a generation of hard-working savers. The challenge is that low rates punish savers and leave them with less income, especially retirees living off their investments.

Interest income has dropped like a rock as the Fed has lowered, lowered, lowered interest rates. My forecast is that you will see 2% yields on 30-year Treasuries and less than 1% on ten-year bonds within the next two or three years.

Better yields can be had with some serious research and homework, but that isn’t obvious or easy. My research team and I believe that a carefully selected basket of high-dividend stocks in the right sectors is the right way to navigate the new minefield of income options. The combination of dividends plus capital appreciation is the only way you can beat the central bankers at their screw-the-savers game.

My friends Barry Ritholtz and Jeremy Schwartz recently completed a study that showed that the highest quintile of dividend-payers in the S&P 500 outperformed the overall S&P 500 by more than 2.5% a year. Over a long period of time, that 2.5% adds up to some serious money.

And those dividend superstars did so with less risk, as measured by lower beta. Heck, even the 2nd quintile beat the S&P by more than 2% a year.

Now, I’m not suggesting that you can buy a basket of dividend stocks, forget about them, and put your portfolio on cruise control. You need to monitor, analyze, nurture, and actively manage your holdings for maximum safety as well as maximum income. That’s good asset management, and it’s exactly what we strive to deliver to you.

Read more from John Mauldin here...

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Yum's Not-So-Tasty Dilemma

Of Black Swans and Survival

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