The Federal Reserve provided a press release on June 18, 2014 to discuss the Federal Reserve Board's Committee position on the present state of the economy and current and possible future actions. The full statement can be seen here on the Federal Reserve website.
The Federal Reserve was purchasing up to $80 billion of Treasury bonds per month up until last fall when they began tapering their purchases. A little history with this, back in May of 2013, the Federal Reserve Chairman at that time was Ben Bernanke, and his official comment to begin the reduction of buying bonds each month sent a shock wave through the market that drove many investment companies' stock price down, as the fear of interest rate risk would cause huge losses. After the initial shock, many companies have created a hedge position to protect their investment portfolios. Since last fall, the Federal Reserve has continued to decrease the bond purchase amounts.
Beginning in July 2014, the Federal Reserve will purchase agency mortgage-backed securities at $15 billion per month rather than $20 billion per month, and will purchase the longer-term Treasury securities at $20 billion per month rather than $25 billion per month.
The Federal Reserve will continue to reduce their purchases until they no longer need to purchase to steady the market. We expect to see the end by the close of 2014.
The Federal Reserve is reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Federal Reserve's sizable holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the dual mandate.
When the Federal Reserve begins to remove policy accommodations, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. Even as employment and inflation reports are at consistent levels, economic conditions may warrant keeping the target federal funds rate down to maintain current growth over time.
This is the key that we see the balance. When, not if, the Federal Reserve does begin to allow interest rates to rise, there will be a counter balance on the housing market. The cost to borrowers goes up, which will limit borrowers to lower priced houses because the interest paid on the money borrowed will eat more of the payment. This will slow the housing market and prevent some from buying in the market. There is a need to allow the interest rates to rise; however, we believe the Federal Reserve will be very careful to limit the upward movement slowly to protect the house market and the financial markets.
Consistent with its statutory mandate, the Federal Reserve seeks to foster maximum employment and price stability. The Fed expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward its dual mandate. The Fed sees the risks for the economy and the labor market as nearly balanced.
The measure of the economy maybe the housing market, along with the financial market that supports the liquidity for business transactions to occur, but we see the labor market as the fuel to keep both markets moving forward. As the employment numbers grow, more buyers can find opportunity to buy homes. The employment number is more important for more Americans to be employed than the unemployment numbers. The growth reported every month is a key factor in the economic recovery.
The Federal Reserve recognizes that inflation, persistently below its 2 percent objective, could pose risks to economic performance. Although the Fed is monitoring inflation developments carefully, there are no current negative effects on the market at this time. If the Fed finds threatening issues, they are likely to find the least obtrusive measures to negate the effects on the economy.
The effect on Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) will be minimal due to the Federal Reserve's position to manage the economic effects on the markets and economy. We are likely to see many of the mortgage REITS, like Western Asset Mortgage Capital Corp (WMC), Armour Residential REIT Inc (ARR), and American Capital Agency Inc. (AGNC) effected by an initial negative wave of losses for the first month(s) or quarter, but would return to profitability soon after. The losses are expected to be tempered due to the hedges the companies currently hold. The long-term opportunity to utilize a larger spread between the cost and what they can charge for money, they would be able to increase their core income.
The outlook for the rest of 2014 is the continued reduction and possible elimination of the Federal Reserve purchasing bonds in the market. The Federal Reserve's current and most repeated goal is to support the economic growth, and provide a monetary policy that encourages growth across many sectors of the economy.
Effects on many companies that participate in the financial markets, especially the housing market, are important and cannot be overstated. These companies could lose millions of dollars through the immediate change of interest rates. Although many companies do have positions leveraged and hedging for the changes, the cost of borrowing money will be a costly change in the market.
The bottom line is the interest rates will rise and many of the companies are working hard to minimize the effects. After the initial changes and costs, many companies will have more room to make additional income due to the spread of borrowing to loaning. The interest rate rise will not be the end of the investment community, but will create more opportunities for companies to adapt in the business market and make profits. We are very positive about moving forward with the opportunities in an improving economy. The companies listed above and many others will provide investors with excellent opportunities into the future. We know interest rates will increase in the future. Prepare for the increase and take advantage of the opportunity.
Disclosure: The author is long WMC, ARR, AGNC. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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