At a time of unprecedented government intervention in the economy, no institution has received more attention than the Federal Reserve. This edition of our market update will attempt to clarify some of the mechanics of the feds basic operations. At the end of this piece you will find some thoughts on how the recent Fed actions may affect the markets and how investors may be able to benefit.
How the Fed Affects the Economy
The fed’s mandate is to promote stable prices, maximum employment and moderate long-term interest rates. A tall order even in normal times. It’s primary tool to achieve this is the effect it has on interest rates through the use of open market operations by purchasing or selling Treasury and agency securities in the open market, a process which alters the size of the Fed’s balance sheet.
The unique power the fed possesses as the central bank is that it can make purchases with its own IOUs rather than selling other assets or borrowing from another institution like you or I would in order to buy something new. When we purchase something new we either have to give up savings, borrow or sell another asset to create funds for the new purchase, not necessarily for the Fed. For example, when the Fed buys Treasuries from a bank, it credits that bank with a corresponding amount of reserve balances (bank funds held on account at the Fed, redeemable for currency). The reserve balances appear as an asset on the balance sheet of the bank, and a liability on the balance sheet of the Fed. The Fed has exchanged its IOU’s – Federal Reserve Balances – for the banks Treasuries. This is what is called “open market” operations.
The key implication of the Fed’s open market operations is their effect on reserve balances. To continue the example above, the Fed’s purchase of Treasury securities increases the supply of reserves in the banking system and with it the monetary base (Fed reserves plus currency in circulation). When people talk about the Fed printing money, this is really what is going on, though technically the physical currency is printed by the U.S. Mint and distributed via the Fed Reserve System as banks convert some of their Fed Reserves to cash to satisfy demands from their depositors.
As a result of the Feds recent interventions there has been an increase in the supply of Fed Reserves being transferred to banking institutions in exchange for their “toxic” assets. An increased supply of reserves in the system will tend to decrease short-term interest rates via its effect on the federal funds rate. This is the rate at which banks lend balances held at the Fed to one another as one bank, finding itself short of required reserves (due to withdrawals) borrows from another that has too many. While this rate only governs the lending of reserve balances on a very short term (overnight) basis, in normal times it will correlate to other short-term rates. For example, direct bank-to-bank lending similar to LIBOR occurs at a higher rate than fed to bank lending. In recent news there was much talk about LIBOR due to concerns about the transparency of assets on bank’s balance sheets along with perceived counter party risk caused the LIBOR rate to diverge from the fed funds rate as banks required other banks to pay higher rates to borrow money. The fed funds rate will normally affect other short-term such as mortgage rates as well, as it affects the terms on which banks get funding to support activity in the markets.
The Shift to Unconventional Policy
If the Fed wants to keep easing policy, it simply keeps making open market purchases which expand the supply of reserve and lower the funds rate. If the Fed were to purchase enough Treasuries or other assets, eventually the increased supply of reserves would be enough to lower the cost of borrowing bringing the funds rate all the way down to zero. This is considered “quantitative easing”: increasing the quantity of reserves beyond the amount needed to push the fed funds rate to its target.
As the funds rate approaches zero (as it is now), many argue that monetary policy doesn’t matter anymore. This is untrue as open market purchases by the Fed would still ease overall financial conditions by raising the price of Treasuries and lowering the interest rate of Treasuries reducing the cost of borrowing for businesses and individuals which in turn would most likely spur economic activity. This sort of quantitative easing, where the Fed is buying Treasuries, effectively increases the government’s borrowing capacity and is referred to as monetization of the government’s debt. Furthermore, the fed could choose to buy or lend against other debt or risky assets mortgage derivatives to encourage a rise in their prices and ease financial conditions.
Since mid September the dramatic surge in reserves is clearly the beginning of a new phase of monetary policy by the Fed. Until September the Fed had offset the effects of its interventions by keeping the size of its balance sheet steady. But in September the Treasury issued a special series of bills and parked them at the fed to allow the Fed to continue to sterilize its operations without expanding its balance sheet paving the way for the creation of the TARP program where the Fed will exchange Treasuries for other assets from troubled financial institutions.
The Fed has gone well beyond its traditional open market operations in this crisis. In an effort to shore up the financial system, it has not been content to sit with a big balance sheet full of Treasuries. Instead, the Fed has:
1. Changed the composition of its assets, by lending cash or Treasuries to market participants in exchange for riskier loans.
2. Taken on portfolio risk from distressed financial firms like Bear Stearns and AIG by insuring a portion of losses from bail outs
3. Used newly created reserves to lend against or purchase assets such as mortgage backed paper to help lower mortgage rates.
What is next for the ever creative Fed? Many are suggesting short of dropping money out of a helicopter the Fed is hard pressed to do much more. With today’s announcement of lowering rates to 0 to .25% it is unclear if we should be excited for the potential this creates in the lowering of mortgage rates, increased potential for banks profitability and potential for increased economic activity or be fearful that so many unprecedented efforts have to be performed to keep our economy alive.
As investors it is our job to find the opportunities which lay within all this change and to seize opportunities as the Fed will eventually have to unwind this new creation of monetary policy. For all intensive purposes we can bet the stronger dollar trade is dead for the short term, however as soon as Europe begins to reduce rates the dollar could see a new bid. This will help strengthen commodity and material prices in the near term. This combined with Obama’s stimulus plan increasing investment in infrastructure now makes basic materials and companies like CAT and Deere a more attractive investment option. As a sister trade to this, the emerging markets look a bit more interesting as most emerging markets are tied to commodity prices. Eventually the fed will begin to unwind the treasury trade which will most likely create a bid in corporate bonds and agency bonds as spreads will begin to tighten. And with rates now at rock bottom the financial institutions should have a chance to increase profits as they borrow from the Fed at ultra low rates and in turn pay us low rates on our money funds and CD’s as they reap the benefits of investing that money in other instruments earning higher spreads.
In the short term we will most likely see an upside run in the equities markets as a result of the Feds actions. I would advise all investors to tread cautiously and not to chase any rallies as we are still in an environment that is filled with unknown and unintended consequences of the Feds actions. Not to mention the risk of deflation, after all, you have to wonder why would the Fed have to do all this heavy lifting if they weren’t afraid of deflation from becoming a possibility. Regardless the “longer term” investment thesis is still challenged as all this transition will prevent any predominant longer term trends from developing. In this environment you focus less on time frame and more on percentage return taking your profits when you have them.
While in our opinion it wouldn’t be prudent to chase rallies we do believe we can begin buying dips with a little more confidence. Without a doubt there will be continued bad news as the economy will continue to struggle through the first half of 09. Historically, the stock markets have turned and begun increases in value on average 6 – 8 months prior to the economy improving. Based on this we wouldn’t be surprised to see the S&P 500 move up to 1000 (now at 900) over the next few weeks barring there isn’t a new surprise around the corner. This would begin a new trading range with the bottom most likely being 850 in the S&P and the top possibly being 1000 to 1050. There is a lot of pent up frustration in the market right now so the first move up could be very quick causing many investors to miss out on the opportunity. This shouldn’t be a big concern, with weak economic fundamentals there will be plenty of market selloffs which will create buying opportunities. As always we will attempt to stay aware of anything that could change this outlook and continue to inform you along the way.
The opinions expressed are those of Colby McFadden as of 12/16/08 and are subject to change due to market and other conditions.