Another Tricky Day

Today, the Fed left the Fed Funds rate at 0.00% - 0.25%. This was expected. What was not expected by the markets, especially the equity markets, was the Fed's lack of color on how and when it will remove stimulus. Yes, the Fed said it would scale back the purchasing of agency debt and agency MBS and be finished with the program by the end of the first quarter 2010. The FOMC also stated that the economy was exhibiting some strength. On the release of the FOMC statement the equity markets sold off and the bond market rallied. Why the counterintuitive response from the markets?

The answer is because the markets, especially the equity markets, believed that the Fed would announce that it would, at worst, announce that it would end its purchases of agency debt and MBS by this October as originally planned or, at best, announce that the economy was recovering sufficiently for the Fed to begin selling its portfolio of agency debt and MBS in the near future. As is typical, the equity markets were overly optimistic (they are also often overly pessimistic) and as a result, the equity markets trended lower. Of course the media published headlines that the Fed said the economy strengthened. Here is the actual FOMC statement:

For immediate release. September 23, 2009.Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn. Conditions in financial markets have improved further, and activity in the housing sector has increased. Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt. The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010. As previously announced, the Federal Reserve's purchases of $300 billion of Treasury securities will be completed by the end of October 2009. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

The real keys to the FOMC statement was that conditions are likely to remain week for sometime and that resource slack continues. The Fed has NO plans in the foreseeable future to raise the Fed Funds rate. It knows what I know. It knows that the consumer is not rescuing the economy this time. It knows that if the Fed stimulus was withdrawn now, the housing market would collapse.

I am not alone in this opinion. CBRE President, Ethan Penner has concerns that real estate problems are not over. In his most recent report he explains how securitization made traditional portfolio lending obsolete and how now that securitization has failed, the global financial system was doomed. He sums up the real estate situation with the following bullet points:

"We are in a process of correcting from historical high valuation - losses cannot be avoided"

"Recent lending standards stunk and most loans originated since '05 are horrible"

" Legacy CMBS market is fragile. PPIP will delay the inevitable."

"Legacy Loans are worth a fraction of face value; less than 80% even for performing loans."

"Unprecedented defaults and loss severity numbers are a certainty."

"TALF is the new repo facility for the bond market and will inspire financing activity once the market clearing begins."

"Cap rates are mostly 8.5% or higher."

"Today because of the shortage of lender equity and the system's need to equitize the lending business, leveraged first mortgage investing provides superior risk-adjusted returns to an equity stratgey."

"The bond market, through CMBS, will not have the day for RE as it didi in the early 90s."

I don't pretend to be as knowledgeable as Mr. Penner (I had the privilege of speaking with him about two years ago and I can attest he is very bright). However, I have long been of the opinion that there is no way to avoid losses due to fundamentals. If a property is only worth "X" in an environment of prudent lending standards then it is worth "X" and there is no way to make it worth more other than repeating the mistakes of the past. We are unlikely to see a repeat performance, at least not this soon after the crisis as investors are wise to just what kind of assests are used in the securitizion process and understand the risks.

The bottom line is that the consumer will be under pressure from declining and lower home values and a VERY poor jobs market. Banks will take more losses as loan valuations will be lowered. This will hold down broad-based inflation. This should keep long-term interest rates from rising too far too fast. Most inflation will be in commodities such as metals and oil as well as food. Price increases of food and energy will crimp growth by acting as a regressive tax on consumption. Those who believe business will pull us out of this economic much are dreaming. Business is reactive to consumers, not proactive.

The recession may have ended, technically, based on GDP, but modest growth due to depleted inventory replacement fueled by record economic stimulus is nothing to write home about. This is why long-term rates remain low and large treasury buyers, especially large foreign investors, continue to buy long-dated U.S. treasuries.

Stay liquid and DO NOT extend far out on the curve as long-term rates will eventually pop. Low-coupon preferreds are especially vulnerable. CDs on the short end, agency bonds 3 - 5 years out and high grade corporate bonds 6 - 10 years out are the best values in the bond market.