Market Update 11 30 10 _ The Fed defends QE2

We’ve heard from a number of Fed officials over the last few weeks.  Three that stand out for the color they provide are the statements from Bernanke, Pianalto, and Kocherlakota.

 

Pianalto describes why she voted the way she did on QE2.  Her speech was given in the aftermath of a blistering round of criticism levied against the Fed for their QE2 plans.  Kocherlakota provides some insight into the “communication value” of QE2 and what it is really telling us.  Finally, Bernanke gives a broad overview of where the economy is currently, and then spends a significant amount of time taking academic shots at other countries.

 

Pianalto

 

She begins by providing the standard boiler-plate that everyone gives at the start of a big picture economic address…we avoided the next great depression…financial collapse…world-wide apocalypse…cats sleeping with dogs…yada yada yada. 

 

Any time you read a statement from a Fed member it’s important to keep in mind that they have the dual mandate of full employment and price stability.  That’s academic talk for keep everyone employed and don’t let prices get out of hand.  Now let’s move on to the important stuff. 

 

She voted for QE2 over her concern about our “uncomfortably low” rate of inflation and the high rate of unemployment.  She notes that over 15 million Americans are unemployed.  In October the economy added 150,000 jobs...this number forms the basis for an interesting point.  In normal times we have 150,000 NEW workers entering the job market each month (as people graduate from high school or college and look for jobs).  So to maintain a given level of unemployment you need to add at least that many jobs on a monthly basis.  The October number is barely enough to get those people to work…much less to start making any progress at putting the other 15 million back to work. This gives some shape to the number of jobs we will have to start posting on a monthly basis to start making a dent in the unemployment rate.  Whatever the number is…it will have to be way higher than 150,000.

 

Cyclical or Structural?

 

Another fact that the Fed wrestles with is the nature of our unemployment.  Cyclical unemployment is your run of the mill stuff…people lose jobs, they are out of work for some period of time and then they go back to work in roughly the same capacity. 

 

Structural unemployment is far more sinister.  This is where the job goes away and it doesn’t come back.  Workers stay unemployed for a much longer time period and ultimately many of them will take jobs for which they have no skills.  This leads to lower productivity, lower pay, and a lower standard of living.  If you multiply this phenomenon across millions of workers you can begin to grasp the magnitude of the problem.

 

Is our unemployment problem cyclical or structural?  Pianalto says that their studies at the Cleveland Fed show that our current situation (while very worrisome) is still a cyclical problem. 

 

While the good news is that we have a cyclical problem vs. the more sinister structural problem, the fact remains that the longer the unemployment rate stays elevated the worse the potential damage is to the economy.  With regard to the Unemployment Rate she doesn’t expect it “to fall below 8.00% before 2013.”  That is an important figure…the Cleveland Fed President…a voting member…expects the unemployment rate to remain above 8.00% for at least two more years.  In my view forecasting the unemployment rate two years from now is like Ray Charles shooting skeet…good luck getting anywhere close to the target.  The fact that her best guess is “it won’t be below 8.00% before 2013” is kind of scary. 

 

With the unemployment piece out of the way let’s move on to her thoughts on inflation.  The Fed’s comfort level on inflation is 2.00%.  As a rule of thumb if inflation is higher than 2.00% they will tighten monetary policy, if it is below 2.00% they will loosen monetary policy.  What could be easier?  They could do that and be having hot wings by noon.

 

When considering inflation, Pianalto prefers to use “core” measures rather than CPI as she believes they provide a truer picture than CPI alone.  Her measures show inflation falling to levels that are unacceptable.  An example she gives is from the October CPI data.  When they drilled down into the data they found that 40% of the items in the basket witnessed price declines while only 12% saw increases of more than 3%. 

 

Inflation expectations are another important consideration.  The most recent analytics from the Cleveland Fed showed that inflation expectations remain “below 1.50% for 10 years and below 2.00% as far as the eye can see”.  Given that their preferred range is 2.00% you start to see why she voted for QE2.  Keep these figures in mind as you formulate your own expectations for how long Fed Funds will remain at zero.  A voting member that uses Fed Funds to influence inflation trends is saying that without QE2 she was seeing at least 10-years of no-reason-to-raise-rates.

 

She points out that while she doesn’t expect outright deflation, she understands that our current scenario of high unemployment and very low inflation are risk factors for deflation.  Additionally she’d be happy to see positive surprises…but there is very little room for any negative surprises in the data.  For these reasons she voted in support of QE2.

 

It is also important to point out that most Fed members seem to support the idea that QE2 will have a modest impact at best…but the alternative is bad enough that it’s not worth the risk of inaction.  Additionally I pick up a rock solid belief from almost every Fed speech I read that they believe they will have no problem at all in pulling back the various stimulus measures if inflation becomes an issue.  They simply have no doubt about their ability to fight inflation if and when the need should arise.

 

In summarizing Pianalto’s views on QE2 I’d have to say it feels like a Hail Mary pass…it’s not something you throw when you’re ahead.  You’ve got little to lose and something to gain so why not throw it?  She saw 10-years of below target inflation (i.e. no reason to raise fed funds) without QE2…so we can reasonably expect that with QE2 she expects inflation to pick up sometime before 10 years…at the same time she expects QE2 results to be modest and unemployment to remain above 8% through 2013.  This doesn’t paint a picture of someone that expects to raise fed funds in the next few years. 

 

And now a more difficult name to pronounce than my own

 

Minneapolis Fed President Narayana Kocherlakota also spoke recently.  He will become a voting member in 2011 and he provided his thoughts on QE2 as well. 

 

Kocherlakota provides us with a target inflation range of 1.50% to 2.50%.  He uses PCE  (personal consumption expenditures) as his benchmark for inflation.  Over the first three quarters of 2010 this measure has averaged “roughly 1.00% at an annualized rate…and is drifting downward.”  Over the prior two years this measure averaged 1.6%.  So this inflation measure is also at the low end of their acceptable range and is moving lower. 

 

Two other factors Kocherlakota points out are that over the last 5 quarters since we “recovered” from the recession the Unemployment Rate has risen slightly; and that GDP has run at only 3.00% and is falling…averaging only 2.00% over the last two quarters.  Some recovery, huh?

 

So he essentially echoes’s the same sentiments as Pianalto: high unemployment, and alarmingly low inflation are on his mind.

 

Actions speak louder than words

 

Over this business cycle the Fed has told us that one way they can manage market expectations is through communication.  Kocherlakota tells us that QE2 can be viewed as a non-verbal communication.  What is it that we should take away from this non-verbal message from the Fed?  Let’s hear it straight from the horse’s mouth:

 

“The November FOMC statement says that the committee will keep the fed funds target range exceptionally low for as long as conditions warrant.  The statement also predicts that exceptionally low fed funds rates are likely to be warranted for an “extended period” of time.  In this way the statement provides explicit communication about the FOMC’s future plans for short-term rates and also shapes the level of current longer-term interest rates. 

 

QE provides a significant supplement to this explicit verbal communication.  The use of QE indicates that the FOMC is likely to keep its target interest rate lower for an even longer period of time.  Indeed, one could readily argue that buying $600 billion of Treasuries is a much more convincing form of communication of the FOMC’s plans than any words could ever be.”

 

Sparking runaway inflation?

 

Kocherlakota addresses criticism that QE2 will spark a wildfire of inflation.  There are two parts to his argument that QE2 won’t serve as “kindling” for a future inflation fire. 

 

First, his basic premise is that there are already over $1 Trillion in excess bank reserves sitting on balance sheets currently…and those trillion dollars have not sparked runaway inflation because they aren’t being lent out.  So his question for the inflation folks is: how will another $600 billion of un-lent excess reserves do something that the first trillion didn’t do?

 

Secondly he points out that the Fed has the tools to fight inflation and that they have the political will to fight it as well.  There is no doubt in his mind that they can and will contain inflation if it starts getting out of hand.

 

He also states that he expects any results of QE2 to be modest.

 

Bernanke is last at bat

 

Chairman Bernanke also spoke…a lot.  Much of his speaking was directed at the differences between established and emerging market economies.  Things like exchange rates and international capital flows dominated much of his discussion.  One could boil this section down to “emerging market countries that blame U.S. monetary policy for their problems need to realize that their problems are their own big-fat-fault because they won’t allow their currencies to float like everybody else does.  If they’d drop or alter their export led growth models things would be better for everyone”.  I’ve taken some liberties there but I think my synopsis conveys the underlying tone of the argument, and I think it is far more interesting to read than the original as well. 

 

The statements he made on the domestic situation run parallel to those made by Pianalto and Kocherlakota.  I could summarize Bernanke’s position by saying the unemployment situation is unacceptable, monetary policy can do only so much but we have to do everything we can within this framework to support the economy, the Fed has the ability to drain the swamp of liquidity when they need to, and that someone needs to balance the budget or this is all for naught. 

 

With regard to his global view one could probably sum it up with the old argument that Americans need to save more and spend less and the Chinese need to save less and spend more.

 

In the end

 

Ultimately the Fed came out of their corner defending their QE2 votes.  They clearly view QE2 as a necessary project that will provide marginal improvement to the economy.  This is done to stave off the potential negatives associated with a further deterioration of the economic data…notably higher unemployment and low inflation.  You wrap all of this up with assurances that the Fed absolutely can and will put the brakes on inflation when it comes back and you get a big expensive program that everyone agrees will have marginal results at best.  What’s not to love? 

 

If you have any questions on this material just let me know.

 

Steve Scaramastro, SVP

800-311-0707

 

Market Update 11 17 10 _ QE2 and the Law of Gross Tonnage

Last week I was fishing on Pickwick Lake.  This is one of several river-lakes that exist on the Tennessee River system and it provides power through its TVA hydro-electric dam, tens of thousands of acres of recreational areas, and important shipping lanes for commerce.

Night had fallen, I was still fishing, and I didn’t have a care in the world.  This is the kind of place that makes you understand how Huck Finn must have felt…it’s just you and the river and nothing else.  At one point I heard some commotion around the bend…it sounded like guys loading a boat on one of the islands in the middle of the river.  A few minutes later it started getting bright, as if the sun itself were about to come around the corner.  Soon enough a very large tugboat rounded the bend pushing 3 immense barges.  This thing was humongous.  I imagine this thing ran several hundred feet end-to-end.  It was B-I-G.

In maritime navigation there is an unwritten rule known as “the law of gross tonnage”.  This rule states that even though you may have the right of way…you don’t want to push the issue with a much larger craft.  As the captain of an 18 foot aluminum hull bass boat I’m acutely aware of which side of the “law of gross tonnage” I fall on in this situation.  If big bertha needs room in the shipping channel then she’s gettin’ it…because I stand no chance of living if I get in her way.  Ultimately this behemoth crawls past me and moves down the river into the night with its two huge spotlights looking out like giant eyes and lighting up the channel a mile ahead.

I make a mental note to stay alert for these things and then I get back to fishing.  A short time later I decide to depart.  I dial up the coordinates for my truck on the GPS, point the boat south, and head down river enjoying the cool air and the stars above.  As I navigate back toward my launch site I come upon the beast again.  It is taking up much of the shipping channel and I consider passing it to save time.  A quick review of the situation yields a long list of things that can go wrong by passing this beast in the dark and a very short list of positives.   They likely can’t see me on radar or by sight and the channel is very narrow so I could run aground or get crushed.  Ultimately I figure better safe than sorry so I hang back a few hundred yards and I’ll just float along behind them until I get where I need to go.

Not long after I settle in at what I deem to be an appropriate following distance I notice some very strange activity.  The boat is acting very squirrely.  The stern is just shifting back and forth and vibrating and the entire boat just feels…shaky.  I’m only doing 5 MPH and there is no wake being put out by this barge…but something is definitely not right.  It took a moment but eventually I realized that I was in the “wheel wash” of the giant barge ahead of me.  The propellers on these boats move so much water that they create a huge swath of turbulence behind them.  As it turns out this is a very dangerous place to be.

Days later I sit at my desk, looking at my Bloomberg and I watch the market deal with the “wheel wash” put out by the Fed.  Like the Tugboat on the river the Fed is the big force in the market right now, they are pushing a huge load of money into Treasuries and their actions will create a significant amount of turbulence along the way.  The last three days of trading have been turbulent to say the least.  We’ve seen the 10-year Treasury trade from a low of 2.60% on 11/12/10 to a high of 2.96% on 11/16/10 to the current 2.82%. 

What should we expect?

The Fed is just beginning on their QE2 journey.  They are pushing a barge filled with $900 billion dollars into this market and they will be leaving lower rates in their wake.  To date they’ve only invested $28 billion.  While Treasury yields have popped up recently I don’t expect that trend to hold up in the wake of QE2.  I continue to view pullbacks as buying opportunities.  I think there will be some opportunity to take advantage of the turbulence as the Fed proceeds.

The headlines are littered with complaints about this program…from foreign leaders to economists it is difficult to find anyone outside of the Fed who is a big fan of it.  I don’t expect those complaints to change the course of this ship.  Almost as if it were in response to the criticism we’ve had several Fed members come out this week and speak in support of QE2.  Just today Bernanke spoke to the Senate Banking Committee and he said that QE2 could create 700,000 jobs over the next two years.  They see this is a very beneficial program on a number of levels.  I wouldn’t hold my breath waiting for the Fed to come out, admit this was all a big mistake, and cancel the spending. 

What’s on the horizon?

This morning we had CPI numbers that lend credence to the Feds argument that disinflation is still a problem.  Every measure of CPI came out lower than the survey estimates.  Tomorrow we get Initial Jobless Claims, Continuing Claims, Philly Fed Index, and next week is full of data. 

The Fed will be buying bonds each day this week.  They have roughly $105 billion to put to work this month and to date they’ve only spent $28 billion.  The next FOMC meeting is on 12/14/10.

What are banks doing?

Activity lately has been brisk with a lot of money being put to work in lower coupon MBS.  This week we saw a lot of 15 yr 3.00% MBS with par handles on them.  This type of structure has a very large fan base.

Additionally we are seeing a continued trend of banks taking gains prior to year end.

If you have any questions or if there is anything else I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

 

Market Update 11 4 10 _ The day after QE2

Traction

Well…it took a day but the market is smellin’ what Bernanke is cookin’.  After yesterday’s FOMC announcement that QE2 was a “go”…the market pulled back a bit.  The 30 year bond had obvious reason to sell off…it will receive no material price support from QE2.  The short end of the curve however will see the bulk of the Feds dollars.  In my view the most interesting thing to happen yesterday was that the 10-year Treasury traded off immediately after the announcement.  It didn’t make much sense and I wrote yesterday that I wouldn’t count on it staying above 2.60% for long.  Mortgages are priced off the 10-year Treasury, and a refi wave is a significant part of the Feds plans, so you know they aren’t going to let the 10-year yield remain elevated.

This morning it appears that yesterday’s FOMC announcement has been fully digested by the market.  The 10-year Treasury is up over ¾’s of a point in price to trade at 2.48%.  It’s difficult to see rates going any higher in the face of the Fed spending $850 to $900 Billion in Treasuries over the next 8 months.  On the upside…for those who were upset that China was the single largest holder of US Treasury debt…rest easy…the Fed will have the title by the end of QE2.  Some really quick math shows they will own roughly $1.2 Trillion in Treasuries by that point…China only has around $800 Billion.  

What’s gonna happen?

There are several pieces of this puzzle at work.  The first impact is that the Fed drives the Treasury curve lower.  Most products that banks invest in are spread to the Treasury curve.  If spreads don’t change and the Treasury curve drops then you will have lower yielding investment options.  We all get that. 

If spreads widen as the curve drops then the downshift in yields will be less pronounced.  Spreads are not likely to widen however as one of the goals of this QE2 program is to make Treasury yields so low that it pushes people out of this sector and into other asset classes.   When investors get to the next market with decent spreads they will squeeze it until the juice runs out…then they will move to the next one and do the same.

The future that the Fed sees is one where spreads on all types of risky assets get tighter…yields will drop on everything as money flees low yielding Treasuries and moves into the next best level.  Agency, MBS, and Corporate bond yields will drop, stock prices will rise, people will feel rich because their holdings have increased in value and while they won’t become the spenders they used to be…they will at least move in that direction.

This leg of the QE2 strategy is to re-inflate asset prices which will usher in the “wealth effect” and get people to spend more.  The wealth effect just means that if you “feel” rich you’ll “act” rich.  For the record I’m not saying I agree with this plan of action…I’m just saying that’s what their plan is…I don’t want anyone trying to kill the messenger here.

The second impact is the Fed’s desire to ignite a refi wave.  This has been an elusive goal from the outset.  It’s important to them, and they are determined to get this done.  If people can refi they will have extra spending money…plain and simple.  Not everyone can refi…but those that can…will.  Driving the 10-year Treasury lower and keeping it low is an important piece of this plan.

We are already seeing increasing prepay activity.  The refi index has more than doubled since May. 

Here is an important point that you probably haven’t heard anyone mention.  While the Refi index will not likely return to the highs we saw back in 2003…it doesn’t have to get that high to wreak havoc.   

In 2003 the mortgage market was very efficient.  Hundreds of mortgage companies were pushing lots of new products that helped virtually anyone refinance.  The refi index surged to 10,000 (recent lows have been in the 1,800 range).  300+ mortgage companies are now out of business, you actually need income to get a loan, borrowers are underwater, and it’s more difficult to refinance now.  So it’s unlikely that we will see another 10,000 print on the refi index…but we don’t need to.

MBS are now trading at much higher premiums than we saw during 2003 so you don’t need speeds to come in as fast to do as much damage.  A lower speed can now cause a lot of damage because many investors are carrying MBS on the books at prices far higher than we saw in 2003. 

Now what?

Where does this leave bank investment portfolios?  It leaves us in a place where the Fed is committed to holding the overnight rate at zero, and just as committed to driving the 1 to 10 year portion of the curve lower as well. 

If you were in the camp that thought the Fed would be raising rates next year it looks like you need to pack up the tent and move.  QE2 won’t even be completed until 2Q 2011.  It’s difficult to see how they’d be raising rates immediately after QE2 expires…and this assumes that they don’t extend it like they did QE1.  To give you an idea of where some of the bigger players see this going, Goldman Sachs predicts that the Fed won’t raise rates until 2015.  It’s officially one day since the announcement of QE2 and the headlines are already appearing about QE3…this market doesn’t appear to have a lot of confidence that QE2 is going to be the fix to all of our woes.

Random notes on investments

MBS

If you are a buyer of MBS we continue to push structure as the primary consideration.  With premiums where they are we continue to prefer the lowest premium we can find, and/or the best structures we can get (those that minimize both the incentive to refi and the risk of negative yields).  Choices are admittedly limited, but as rates drop we will be seeing more low coupon MBS come to market at lower prices which should help.

The landscape is currently littered with bonds that have negative yields under prepay scenarios that aren’t far off current levels.  We have a report that can show your book yield under the 1, 3, and 6 month historical CPR speeds, AS WELL AS the Bloomberg Prepay Model shock scenarios.  If you own any MBS at higher premiums you will want to see this report.  If you were pursuing a strategy of buying high premium MBS because they wouldn’t prepay then you definitely want to see this report. 

If you’d like me to run this report for you just shoot me a copy of your most recent bond accounting report (including your book price).  If you send this in electronic format (excel or PDF) it should be less than 24 hour turn-around time on the report.

AGY

The Agency market continues to see a huge amount of step-up structures.  Step-ups remain a popular way to pick up yield in the Agency market. 

Shorter final Agency paper is-what-it-is…yields are low and getting lower.  This morning a new issue 3 yr non-call 3 month came at 0.80%.  In some cases (as recently as this morning) we can find very low premium CMO’s that beat short agency callables under almost all rate scenarios. 

Muni

Muni’s continue to do well as a wide swath of this curve still offers spreads of +100 to Treasuries.

SBA

For those that want yield 20 year Fixed Rate SBA bonds continue to sell briskly.  These offer a full faith and credit (zero risk weight) investment with an average life anywhere from 5 to 10 years and yields north of 3.00%.  These trade with larger premiums (105 to 112) but historically they’ve paid slowly.

Floating Rate SBA’s are at the other end of the spectrum.  If you are concerned about rising rates/inflation then you can get a full faith and credit piece that floats quarterly off of Libor with no cap.  Structures vary.

That’s all folks

That’s it for now.  The market is rallying, yields are going lower, and stocks are moving higher.  If you have money to spend I would spend it sooner rather than later.  If you think these yields are ugly just wait until you see them after the Fed has spent another Trillion dollars on Treasuries. 

If you have any questions or if there is anything I can do for you just let me know.

Steve Scaramastro, SVP

800-311-0707 

 

The short story on the FOMC statement

 

The Fed announced that they will buy a total of $850 to $900 Billion worth of Treasury securities through the end of the 2^nd quarter of 2011.

 

$600 Billion of this will be new money…the remainder is the reinvestment of portfolio cash flows.

 

They will distribute their purchases per the following schedule (from the FRB NY website):

 

 

 

Market activity thus far has been interesting.  The long end of the Treasury curve is left out in the cold…they won’t be buying much there at all.  As you might expect the long end has sold off a good bit.  I looked at the 30-year just before the announcement and it was up almost a point.  Since the announcement it has given up that amount…and then fallen another point and a half to trade at 4.03%.  The market knows that the long end will receive no support so there is no point in being there.

 

The short end of the curve (the 1 to 10 year range) is also undergoing some interesting changes.  The 10-year Treasury actually pulled back (down in price, up in yield) after the announcement.  Prior to the announcement it was trading at a 2.53% and it is now at a 2.60%.  I’m not sure what is driving the pullback…there is a LOT of noise in this market.  The Fed is clearly on a mission to drive rates lower so it would seem that any pullback to higher rates in here will be short lived.

 

Time will tell…but the Fed has shown their cards.  They are betting on lower rates, they are willing to spend a LOT of money to it done, and they can print as much money as they need to stay in the game.

 

If you have any questions or if there is anything I can be doing for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707