The market response to the last FOMC meeting left many participants scratching their heads. Heading into the meeting, institutional investors wanted a magazine check on the Fed’s Glock to see if any bullets remained. The Federal Reserve did not flinch, in my read anyway. However, the ready-fire-aim high frequency traders prevalent market we reside promptly, “sold the bugle and bought the drum.” (An old war term - when the soldiers would march into battle, they would hear the bugles off in the distance. It was prudent ammo conservation to wait until they saw the drummer to begin discharging their weapon; plus, this gave them a much better chance at hitting someone at that distance than just shooting off.) Put another way, sell the rumor, buy the fact. This Friday we heard from Fed Chairman Bernanke and the market responded with a sigh and a nice recovery short covering rally.
The rumor first. The Federal Reserve announced that due to uncertain conditions and a modest recovery they would maintain their virtual zero interest rate range of 0%-.25% for an extended period. No shocker there; this came as was expected. The was followed with this statement:
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.
That statement was the response to the market demanding a Glock check. Aggressive and opportunistic HFTs, sensing market confusion on what this last statement meant, sold persistently. Some had interpreted this statement to be a fresh Quantitative Easing program further ballooning the Fed’s balance sheet.
Was this the case? Not at all, in reality. Here’s the scoop. The Federal Reserve’s Quantitative Easing program has resulted in the purchase of $1.25 trillion in Mortgage Backed securities. The intended effect - to keep the mortgage market liquid and lending rates low. It is by any measure a huge success. The Federal Reserve is making money on their investment, which in turn is given to the US Treasury, as it should. Mortgage lending has rebounded smartly. Mortgage rates have been pushed down to new lows, benefitting home buyers, the housing and construction industry, and folks needing to refinance.
This last group is key to this conversation. Refinancing activity, with interest rates at such low levels, has been booming. Those loans, which were securitized and purchased by the Federal Reserve, are now being paid off; the result is that the Fed is getting their money back. Now if the Federal Reserve does nothing with those monies their balance sheet obviously would shrink and money would be extracted from the banking system, resulting in a de-facto tightening of policy (higher interest rates). The last thing this struggling recovery needs is higher borrowing costs.
So, instead of allowing these refinancings to wither away the size of the Fed portfolio, they will reinvest those monies into longer dated Treasuries in an effort to keep their portfolio size constant. The figure I’m hearing is close to $400 billion over the next twelve months.
What is also delightful to see, planned or not, is that we are getting the Fed out of the way of the mortgage market... slowly but surely. Which is what investors should and do want. The capital markets need to be free to operate. Let the free market determine how to price risk appropriately. With the Fed involved (as I believe it needed to be, past tense emphasized) we cannot price risk appropriately, because the presence of the Fed is skewing the equation.
Think of it this way. Without Fannie Mae guaranteeing loans and without the Fed purchasing those loans, would banks be lending money for 30 years at 4 ½%? In this type of economy? No way! When we can extract the Fed and see what rates investors/lenders demand, don’t be surprised to see 7 ½%-8% mortgage rates. However, how to clean up the mess home builders, mortgage brokers, appraisers, speculators, overextended borrowers and bank-sters created, and clear the huge inventories of unsold or foreclosed homes' ultra low rates, remains the tonic of the day. We’re most likely in this low rate environment for another twelve-fifteen months before we will even make a dent in the stockpiles of housing inventories. Where rates go may finally be determined by a market free of FNMA, Freddie Mac and the Federal Reserve.
As I said earlier, we gained a confirmation of what the Fed actually stated in their release on Friday from the Jackson Hole Wyoming, Kansas City Fed hosted Economic Symposium. St. Louis Fed President James Bullard, in a CNBC interview, when posed with the question concerning a shrinking or expanding Federal Reserve balance sheet, responded somewhat annoyed, “Were we not clear?”
The question was put to him by one of the chief economists of Pimco, the world's largest bond fund manager. I was a bit surprised at the question, as I thought the statement was crystal clear. Unfortunately not to enough of us lemmings. Which explains some of the price action in the market leading up to Friday’s second quarter GDP revision and Jackson Hole symposium. The GDP revision wasn’t as severe as the oracles on Wall Street had scared some to believe. The Bernanke Glock check revealed that he’s still got a few more left in the chamber should the economy turn down meaningfully. This soothing of investor angst allowed for a nice relief rally of 17 points on the S&P 500 heading into this beautiful weekend
I'm going to keep this one short and sweet. In this uncertain, range bound market we find ourselves and positive returns tough to come by; when you have an opportunity to secure 8 1/2 yield on a utility with the opportunity for capital appreciation you have to take it or begin to question what you're really trying to accomplish. Are you an investor or a trader? When it comes to investing in a challenging market, I fall back on the old adage: K.I.S.S - Keep It Simple, Sister. Keeping it simple here points me to PPL-U 9 1/2% convertible preferred, a plain old utility with a very attractive yield for those seeking income and those looking for an opportunity of capital appreciation with a cushion.
In a note of full disclosure, I may currently own or look to own in the future shares of PPL-U or PPL for myself or my clients. Before making any investment decisions, please do your own due diligence and consult your investment professional or myself. .
Disclosure: Author holds positions in PPL-U, PPL