No Rates A-Risn'

No Surprises From The Fed

To the astonishment of no one, then Fed left the Fed Funds rate unchanged in a range of 0% to .25%. The FOMC also stated that such accommodation will remain in place for "an extended period of time". Some market participants were hopeful that pronouncement would not appear in today's statement. The Fed is not as optimistic as the numerous Pollyannas who pervade the market.

The following paragraph says it all:


"Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly. However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level, and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability."

To me it sounds as though the Fed may be more concerned with deflation than with inflation.

Too many people look at one side of the inflation coin. They look at the amount of debt the government is issuing and the amount of dollars it is printing and automatically assume that prices must rise. This may be true of imported commodities, which are all denominated in dollars, but as we have seen with the disconnect between the Producer Price Index and the Consumer Price Index, prices cannot always be passed onto consumer. Demand has just as much to do with pricing as supply. If a significant number of Americans are unemployed or underemployed, demand will be slack and prices will be little changed on a broad measure.

Even the Obama administration believes that unemployment maybe high for a prolonged period of time.

Treasury Secretary Timothy F. Geithner, White House budget director Peter Orszag and Christina Romer, chairman of the Council of Economic Advisers, said in a joint statement"


The percent of Americans who can't find work is likely to "remain elevated for an extended period," The officials said unemployment may even rise "slightly" over the next few months as discouraged workers start job-hunting again.

"We do not expect further declines in unemployment this year," the officials said in testimony prepared for the House Appropriations Committee. They also predicted the economy would add about 100,000 jobs a month on average -- not enough to bring the jobless rate down substantially


So why did the equity market rally, albeit modestly, following the Fed's statement? Because the cost to borrow will remain cheap (Three-month LIBOR is about 0.26%). It is cheap for market participants to borrow and play the markets. This is how asset bubbles develop. Whether or not the equity markets develop into a true asset bubble depends on whether real economic growth catches up to the markets. Both the FOMC statement and the joint statement from Treasury Secretary Timothy F. Geithner, White House budget director Peter Orszag and Christina Romer cast doubt on this.

So what should investors do? Buy large cap, blue chip, dividend-paying stocks. Do this until the Fed removes the cheap leverage punch bowl. At that time, there could very well be a correction of some kind. When that happens, jump in with both feet.

In this environment fixed income investors are truly income investors. Market timers can get their clocks cleaned. Investors staying exclusively on the short end of the curve will earn so little in the way of yield, Arthur Burns would have to rise from the dead and re-assume control over the Fed to make rolling at higher rates profitable. Investors pegging the long end of the curve could get hammered should the economy unexpectedly gain traction and inflation materializes. What about LIBOR-based floaters? Ha, ha, ha, ha!!!


Fixed income investors should ladder or barbell their portfolios. CD's short, callable agencies intermediate and bank and finance corporate bonds in the 10-year area. Avoid the long end as one is not sufficiently compensated in terms of yield. Subordinate debt issued by high-quality banks offer decent yield pick up.

Investors looking for floating-rate obligations should look for structured bonds, such as range accrual notes which pay an attractive rate of return (fixed or adjustable) as long as the observed benchmark remains within the stated range. Doing this can enable investors to avoid the hazards of having long-term security with coupon adjusting off of a short-term benchmark. If you want to float off of rising long-term rates (when and if that occurs), buy a security which adjusts off of a long-term benchmark.

Happy St. Patrick's Day!