I am Oz, the great and powerful.

In 1939 Warner Brothers released the American movie classic The Wizard of Oz.  Over ensuing generations the story of Dorothy and Toto being swept away to the magical land of Oz by a Kansas tornado has been told and re-told countless times.  While there are many notable characters, the Wizard may be the most intriguing.  Recall that when the intrepid band of travelers arrive at the Emerald City to ask the Wizard for help, they soon discover that the Wizard is ”the man behind the curtain” pulling levers and pushing buttons in order to keep Oz running smoothly.  This got us thinking – Has Fed Chairman Bernanke been channeling his inner wizard?   Over the last 12 months we have opined on several potential economic turning points, from Washington’s broken politics -- to how the US inches ever closer to the fiscal precipice - to the (continuing) debt laden drama playing out in the Euro zone.  Embedded within each commentary detailing these impactful situations was our belief that US interest rates are TOO low and, except for direct actions by the Federal Reserve, market participants would move Treasury rates higher, perhaps significantly so.  To date we have not seen a significant and sustained rise in Treasury rates -- as such, it behooves us to review and challenge our assumptions/opinions regarding the current level of interest rates.   It is clear that US equity markets have shrugged off the aforementioned impactful situations leaving Treasury yields during the latter part of 2011 below core inflation for the first time since 1980.  Note that this Fed’s preferred inflationary price gauge is the core Personal Consumption Expenditure (PCE) index; Bernanke has indicated that he chose this index as the basis for the Fed’s inflation target because it better reflects changing purchasing habits of individuals.  However, it makes no difference whether we consider CPI or PCE because based on the historical relationship between economic growth and real yields, 10 year Treasury yields appear to be approximately 1% to 1.5% below expected levels. Much like the Wizard in Oz, the Fed has pulled levers and pushed buttons to manipulate and manage rates  down to levels that are TOO LOW.  This begs the simple question – Why?  Or more accurately why has the Fed continued to do so?   The Fed has historically opened its tool box during times of economic stress/crisis.  History shows that the Fed using economic tools is indeed standard behavior — Macroeconomics 101 tells us that the most effective tool the Fed has - and the one it uses most often - is the buying and selling of government securities in its open market operations. The Fed will buy securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow.  In the simplest example the Fed purchases securities from a bank and then pays for the securities by adding a credit to that bank's reserve for the amount purchased. The bank can then lend the newly added money to another bank in the federal funds market.  Interbank (reserve) lending increases the amount of money in the banking system and lowers the federal funds rate.  When the Fed funds rate is decreased this example of expansionary monetary policy ultimately stimulates economic growth, exemplified by increases in business and consumer investment/spending.   Reviewing first quarter indicators it certainly appears that the US economy is on an increasingly positive trajectory—Industrial Production has been trending positively, the same is true (over the past 6 months) of new orders of durable good; automobile sales have crested 15 million units for the first time in years.  Perhaps the Fed’s use of TWIST since the latter part of 2011 while the banking system was/is already awash with liquidity shows Bernanke’s continuing uneasiness about the current economy.   Obviously he is motivated to get this right and over the recent past Bernanke has been both praised and criticized over Fed action during the current challenging times.  We submit that given the aforementioned bright spots as well as solid first quarter profitability being reported by companies and higher than expected consumer spending, Mr. Bernanke should take a lesson from former chairman Volcker and place his faith in the capital markets.  He should take his foot off the monetary gas pedal  and let the fruits of his energy and labors present themselves.   Simply put- Bernanke should remember that doing nothing IS doing something and he should allow the markets to work without over extensions of liquidity by the Fed.   With capital market indexes cresting highs, equity investors should be wary as they follow the yellow brick road for the wizard is holding rates TOO LOW and a tornado of rising rates may be just over the horizon.  While no one can ever be certain what the future holds, one thing is true—Toto, I've a feeling we're not in Kansas anymore.