Newsletters 2010 Newsletters Bernanke and the Three Bears
Wednesday, 10 March 2010 20:56
After reaching the precipice of its first 10% correction since the March 2009 lows, the stock market found its footing, with the S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite rising 2.85%, 2.56% and 4.28% respectively in February. Year-to-date through February, these important market barometers remain slightly in the red, with the S&P 500, Dow Jones and NASDAQ down -0.95%, -0.99% and -1.36% respectively. With the one-year anniversary of the March 10th bottom upon us, the stock market is poised to push through recent highs and into the black for the year.
On February 18th, the Federal Reserve raised the discount rate, the rate it charges banks for emergency loans, by twenty-five basis points (.025%) to seventy-five basis points (0.75%). During more normal economic times, the discount rate has historically been kept one percentage point higher than the more important Fed funds rate, the rate that banks charge each other for overnight loans. With the Fed funds target rate currently pegged at an unprecedented low level between zero and 0.25%, a “normalized” discount rate would be between 1.00% and 1.25%.
While the Fed stated that the move didn’t “signal any change in the outlook for the economy or monetary policy”, the largely symbolic gesture still led to rampant speculation that the de-facto period of Fed tightening had unofficially begun. The Fed further stated that “these changes are intended as a further normalization of the Federal Reserve’s lending facilities”. This process towards “normalization” really began last October when the Fed allowed the Money Market Investor Funding Facility (MMIFF) and the Treasury Securities Purchase Program to expire. In addition to the hike in the discount rate, February also witnessed the expiration of the Fed’s Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), Commercial Paper Funding Facility (CPFF), Term Securities Lending Facility (TSLF) and Primary Dealer Credit Facility (PDCF).
As the alphabet soup of crisis-prevention liquidity is gradually removed from the market, it is clear that the Fed is preparing us for the inevitable day when interest rates must rise. While Fed Chief Ben Bernanke continues to telegraph that the Fed funds rate will remain at a low level for “an extended period”, the futures markets are predicting an approximate 85% chance that Bernanke will raise the Fed funds rate by twenty five basis points (0.25%) to 0.50% at the November meeting of the Federal Reserve Open Market Committee (FOMC).
Fittingly, the odds for such an increase rose markedly after it was reported that nonfarm payrolls fell by 36,000 in February after declining by 26,000 in January – the consensus expected payrolls to decline by 68,000. Remember, the economy lost an incredible 779,000 jobs in January 2009. Just before this better-than-expected report, the Fed funds futures were pricing in a 70% chance for a November rate hike and rose to as high as 90% before settling in the mid 80% range. It has been widely expected that Bernanke would keep the Fed funds rate at its current level until the economic recovery were sustainable enough to create new jobs. What makes this particular jobs report all the more impressive is that severe winter conditions had no impact on employment (the consensus expected the loss of 100,000 jobs due to weather) and the underlying number of employed actually increased by 308,000, along with the total number of workers, as the unemployment rate held steady at 9.7%. Unemployment has always been a lagging indicator and it appears that we are finally seeing it turn the corner. Ironically, there may come a time in the not too distant future when a particularly strong employment report, while an encouraging sign that the economic recovery is on a more self-sustaining path, will be greeted by a sell-off in the stock market as traders fret the timing and trajectory of the Fed’s next rate hike cycle.
While the recent hike in the discount rate provided more headline risk than any material policy shift, the imminent expiration of the Fed’s $1.25 trillion mortgage purchase program this month bears watching for its impact on mortgage rates. After all, it was the housing and credit bubble that got us into this mess in the first place and real estate, particularly commercial real estate, remains among the most fragile areas of our economy. While there is no debate that the decline in residential real estate has finally reached a plateau, commercial real estate markets are still groping for a bottom. Meanwhile, recent reports indicate that housing may not yet be out of the woods. New home sales fell from 348,000 in December to 309,000 in January, while the median price for new homes dropped to $203,500 from $215,600. Meanwhile, existing home sales declined to 5.05 million homes in January from 5.44 million homes in December, while the median price of existing homes fell to $164,700 in January from $170,500.
The fact that home sales have fallen in December and January, after having risen in each month from August through November, can be directly tied to the expiration of the first-time homebuyers’ tax credit at the end of November. At the very least, it remains to be seen whether the housing market can sustain a prolonged advance without government intervention. Now that the Fed’s extraordinary liquidity will be removed from the mortgage-backed securities market, mortgage rates may rise and limit the prospects for any robust turn in housing. Amazingly, 24% of all residential properties with mortgages, approximately 11.3 million homes, were “underwater” at the end of 2009, meaning the value of these homes is less than the debt owed on them. There were another 2.3 million residential properties at year end where the home was within 5% of negative equity. The drop in housing prices in December and January and looming threat of rising mortgage rates does not bode well for this substantial portion of the residential market.
We remain cautiously optimistic that recent positive trends in employment will eventually trump recent negative trends in housing. In his recent annual letter to shareholders, Berkshire Hathaway’s Warren Buffett predicted that the United States will recover from the housing slump by 2011: “Within a year or so, residential housing problems should largely be behind us. Prices will remain far below 'bubble' levels, of course, but for every seller or lender hurt by this there will be a buyer who benefits. Indeed, many families that couldn't afford to buy an appropriate home a few years ago now find it well within their means." While we agree with Warren, we will be watching interest rates and Fed policy closely to gauge the potential for disruptive market dynamics or premature policy moves.
The Fed is truly walking a tightrope. Do they keep rates low for the benefit of employment and housing, and risk higher inflation or a potential “bond bubble” down the road? Or do they raise rates for the benefit of bond vigilantes and foreign investors, reminding the market that controlling inflation remains the Fed’s primary responsibility? The answer may lie in the fact that inflation trends remain largely subdued, offering the Fed cover in its quest to reinvigorate economic stability. However, in continuing to keep rates low for an extended period, the odds rise for a Greenspan-like, “too low for too long” policy error. If “Papa Bear” is hiking rates too quickly and “Mama Bear” is not raising rates fast enough, we hope Bernanke can channel his inner “Baby Bear” and find that “just right” balance. Whether “Goldilocks” returns to the economy will depend on it.
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