The longer sluggish economic growth persists, the greater the damage to the long-term economic outlook. Thus, Fed Chairman Ben Bernanke still has a bias to ease policy and clearly sees room for additional stimulus should the economy not pick up or unemployment not subside. In addition, inflation numbers should moderate in the third quarter, implying that inflation will not be a constraint on additional easing.

Bernanke did not announce any huge policy changes at Jackson Hole because probably:

  1. Following his announcement of quantitative easing two (QE2) at Jackson Hole last year, he didn’t want to set an annual tradition specifically around Jackson Hole
  2. The FOMC wants to see more economic data before embarking on new policy
  3. Although the economy is weak, it is not cataclysmic
  4. He is waiting for Europe to return from summer recess and make their own announcements/fixes regarding their own sovereign debt crisis

Thus, market focus will be on the newly expanded two-day September FOMC meeting.

The Fed’s next course of action may be to either announce purchases of mortgage backed securities (MBSs) or a maturity swap within its balance sheet, designed to further flatten the curve. A maturity swap (a.k.a. twist) would sell T-bills and short term Treasuries and use the proceeds to buy longer dated Treasuries. This is appealing because it would not involve any expansion in the Fed’s balance sheet, and would expose the Fed to less political criticism than another round of quantitative easing. The twist in the yield curve would drive down intermediate- and long-term yields by removing duration from the market; operation twist would remove about $430 billion to $630 billion in 10-year equivalents from the market. Interestingly, this would be similar to the $660 billion and $420 billion of 10 year equivalents removed by QE1 and QE2, respectively.

In short, the Fed continues to push investors and people toward taking risk. We enter August optimistic that decent opportunities will arise, but watchful for further short-term correction. Following recent market turmoil, CEFs yields are especially attractive relative to the current yield hungry environment we are in and many CEFs have underlying net asset values that continue to perform well. Covered call, mortgage, diversified and convertible CEFs as well as some equity CEFs seem to offer good projected relative value opportunities versus TIP and investment grade CEFs which may be overstretched. Expect bankruptcies and defaults to remain low in the near term.

Michael Ashley Schulman, CFA
Managing Director
Hollencrest Capital Management