After admitting that the current economic conditions pose “significant downside risks” to the recovery, the Committee reached the decision to alter the composition of their $2.9 trillion balance sheet:
In what has been named “Operation Twist” from a similar measure taken nearly 50 years ago, this tool is designed to reduce long term interest rates, which essentially makes the cost of capital cheaper for businesses and consumers to boost borrowing and spending.
The Fed has been under enormous pressure and scrutiny over the last several unorthodox attempts at easing monetary policy, particularly the last two rounds of Quantitative Easing (QE1 and QE2), which bloated the balance sheet to its current level. The side effects have had a profound impact on consumers because of sharp increases in inflation and prices.
Not only have nearly 30% of the voting members on the Committee officially dissented to additional easing measures, but the Republican leadership in Congress made their feelings known by sending a stern letter ahead of this meeting to the Fed Chairman warning not to engage in further easing for fear of higher inflationary conditions.
So it appears as if there won’t be a QE3 anytime soon, unless the economy takes a severe turn for the worse. The markets were sorely disappointed by this revelation, as they tumbled nearly 3% after the announcement yesterday afternoon, and are off to an even worse start today as I write this.
Aside from the portfolio shift further out along the yield curve, the Committee did make another compelling change to policy:
This is clear evidence that the Fed is trying to do everything possible to “twist the arms” of the American consumer -- particularly those who’ve been sitting idle on the “white picket” fence -- to go out and grab their piece of the “American Dream” and buy a home.
In their last policy statement in August, the Fed implicitly pledged to keep short term rates low until 2013, which also drove down longer term rates further out along the curve. Last month’s actions dropped mortgage rates to historic lows.
Yesterday’s reading on Existing Home Sales showed a month over month jump of almost 8%, to an annualized rate of 5.03 million homes sold.
Now, instead of reinvesting the proceeds from maturing mortgage backed securities directly into Treasuries like they have been doing, they will reinvest the proceeds directly back into mortgage agency debt (Fannie and Freddie), which should squeeze mortgage spreads to tighten and lower residential mortgage rates even further.
The Fed is indeed doing everything that it can to boost the housing market while not increasing the balance sheet. I would not be surprised to see the average 30-year fixed mortgage rate being quoted below 4.00% as early as next week.
More Arm Twisting?
As the equity markets were digesting the fact that no QE3 was imminent, the bond market on the other hand was flying on the news.
The 10-year Treasury note yield dropped to 1.87% -- a level not seen in over 70 years! The 30-year yield also dropped sharply to 3.04%. With the Fed pledging to buy over $100 billion on the longer end of the curve, the 30-year yield has more room to fall. Towards the end of the last credit crisis in late 2008, and in the teeth of a nasty recession, the 30 year yield actually dropped to 2.52% briefly -- so there’s plenty of room to go.
If you thought it was getting tough to find somewhere to park your money with decent yield ... well it’s about to get even tougher.
The Fed Chairman certainly doesn’t discriminate when it comes to policy. He doesn’t care if you’re a fresh out of college new employee eligible to contribute your first dollar into a 401k. He doesn’t care if you’re a middle aged investor looking to diversify your portfolio. And he doesn’t care if you’re retired and in need of income generation and safety to live off your nest egg.
The Fed’s monetary policy is designed to steer money away from safe haven securities and cash, and into riskier assets and securities like stocks and equity investments. He’s trying to prop up the stock market, which will boost consumer wealth and increase confidence and spending. It’s a broad plan that is supposed to snowball into higher gross domestic product growth.
By driving rates to the ground, he’s essentially “twisting your arm” to steer your portfolio into equities and riskier assets.
The New Bond Market
While risk free rates are now less than 2% on 10 year paper, and are about to go below 3% on 30 year paper, it's become worth asking:
Are relatively safe, high yielding equities the new safe haven?
It’s starting to look like the investment environment is making a transformational change.
Take, for example, Microsoft Corporation, Symbol: MSFT.
The Company has a fortress balance sheet with tons of cash. Its debt rating and safety compared to the United States Government is probably superior on many levels if you polled the smartest analysts on Wall Street.
The stock closed at 25.99 yesterday and is trading at 9.6 times this year’s earnings, even less on next year’s. That’s over a 10% earnings yield per share. And, the company yet again raised its common share dividend distribution earlier this week by 25%. MSFT now pays 0.20 per quarter, or 0.80 per year. That means at the current stock price, the security is yielding 3.07%, which is higher than the current 30 year Treasury yield!
So I ask you, will this latest attempt to further ease policy by implementing the “twist” tool to drive down long term rates even lower help the economy? Will it be effective, or will it be another desperate attempt to mask the real problems that plague the U.S. economy?
Fed policy has certainly been a highly contentious subject of late. Feel free to post your comments and opinion on how you feel about this latest policy maneuver.
Channel Trading Secrets