In his press conference this week Chairman Bernanke said that the FOMCís objective was to communicate clearly to avoid market dislocations about its policy intentions. Iíd give them an ďFĒ on that assignment.
The Fed dropped a major ďhuh?Ē on the markets. After a summer of hinting that QE tapering was about to start, the Fed did an about face in their meeting this week. Not only is QE tapering not about to start, it might not start for many months. The Fed statement on rates declared that, while risks to economic growth were receding, the forward pace of growth was not sufficient for the FOMC to deviate from its current pace of asset purchases. The Fed will continue for now to purchase $45 billion in Treasury paper and $40 billion in MBS product per month. In the press conference that followed the release of the rate statement, Bernanke shrugged that the Fed might start tapering before the end of the year but the decision to do so would be entirely data-dependent.
The Chairman stated that the FOMC had been encouraged by the data flow at the time of the June FOMC meeting, but that subsequent data had cooled. Hence, no need to change policy in September. He claimed that one of the reasons for this cooling was the rise in rates that had transpired since early May. Bernanke suggested this was a headwind to forward progress, particularly in housing where mortgage rates have shot higher. However, rather than concede that the main reason rates went up was the loose talk from Fed officials about QE tapering (including from the Chairman himself at the June press conference), the Chairman offered that rates had gone up because markets saw improvement in the economy. Yet the Fed cited a lack of improvement as their reason for not tapering QE now.
Bernanke also offered that some of the rate dislocation was from investors exiting riskier positions. Some of those risks were in emerging market stocks and bonds. The Chairman thought this was a good thing. As investors sniffed QE tapering in the air, they exited those risky trades sending shock waves around the world. I guess the Chairman has now given the green light for those risky positions to be reestablished.
When challenged that the Fed has misled the markets about the possibility of QE tapering coming out of this meeting, Bernanke smiled and commented that he never said anything about tapering now. (Letís hear from some of the other FOMC members about this, shall we?) Fed speakers maintained a nonstop rant about tapering since early May. Bond market investors basically decided this summer that the Fed had lost credibility and headed for the exit. Bernanke acted like he had nothing to do with this. If he didnít think that markets were looking for some sort of tapering this week, he is being rather coy.
Another reason cited for not tapering was lowered near-term economic forecasts by the various FOMC members. They shaved their expectations for growth in 2013 and 2014, pushing the long-expected bounce out into 2016. A reporter asked Bernanke why he was confident about these forecasts since they havenít been right for years, as the Fed has consistently over-estimated actual growth. He danced around the question which is too bad because it is these same forecasts that will determine future monetary policy.
Bernanke was asked about recent studies that show the effectiveness of QE to be diminishing. He said he had seen those studies but felt the decline in the unemployment rate was evidence that they were doing some good. He would have been more accurate pointing to the stock market as proof of QE success, since it was weak stock markets that produced the past rounds of QE.
If there was any doubt on that point we only have to look at the marketís reaction to the Fed decision. Stocks jumped higher then went higher still. The S&P made an all-time high in post-FOMC trading. The Dow added +147 points. Break out the party hats! However, stocks werenít the only markets affected. In a single blow the Fed produced a huge rally in Gold (+$56 and climbing) and Crude Oil (up almost $3.00 per barrel). In fact, almost every commodity in the CRB rallied on the news. The Dollar tanked, making a low not seen since February. As I think about the Fedís mandate, I would add a stable currency to the goals of full employment and stable inflation. I donít recall reading that these goals included pumping up stock prices.
Interest rates dropped like a stone. I have no idea how long this new-found enthusiasm for bonds will last. Lurking in the wings is the upcoming debate on a continuing resolution and an increase in the debt ceiling. A possible government shutdown does seem to be getting some ink. Bernanke was asked about this and he conceded that this possibility did influence the non-tapering vote. I would remind the Chairman that it was the impending fiscal cliff at the end of 2012 that produced QEIII in the first place. The Fed is stuck. They concede that QE is losing its effectiveness but cannot withdraw it without roiling financial markets. The Fed has boxed itself into a corner.
Director of Investment Sales
Jeff's comments and insights, based on his professional expertise and the knowledge he has acquired observing the U.S. economy and global markets, are offered as his own personal observations and opinions, and not necessarily reflective of those held by SunCorp, our board or member credit unions.
How we got into this mess
Ever since these mortgage behemoths were conserved during the financial crisis of 2008, the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (Freddie Mac) have been under governmental orders to shrink. There is even legislation underway in Washington to eliminate these enterprises entirely.
Over the last twenty years, FNMA and Freddie Mac became a larger and larger share of the mortgage market. In addition to buying mortgages from Credit Unions and other financial intermediaries with the express intention to pool the loans and resell them into the market, FNMA and Freddie decided to buy the loans outright. These purchases were financed by debenture sales into the capital markets. Taken together, the MBS collateral, CMOS (made for other MBS collateral), and agency debentures (securities issued by them but not specifically backed by mortgages, rather the general credit of the company) dominated the kinds of assets that credit unions would buy to satisfy their investment portfolio requirements.
Once these two GSEís (Government Sponsored Enterprises) folded, we taxpayers were on the hook for their losses. The government has decided enough is enough.
The government moves to shift risk from the taxpayer to the institutional buyer
To meet a regulatory directive, FNMA and Freddie are being forced to liquidate large blocks of mortgages they still own from prior to the real estate collapse in 2008. The big change is that these securities will be sold without government backing. This means that the buyer of the securities will be on the hook if we go through another credit event. The implied full faith and credit support historically provided by the government is effectively gone.
New sales have already gotten underway
Freddie has already launched one such deal, a 500-million dollar sale this summer. The Freddie version is called STACR (for Structured Agency Credit Risk). The initial sale was a two-tranche deal, both floaters with wide yield spreads. The 2-year tranche was spread +340 basis points over 1 month LIBOR. The 8-year average life deal offered a spread of +715 basis points. The credit enhancement was subordinated collateralization, meaning that the amount of mortgages backing the deal was greater than the par amount of the bonds sold, with the extra bonds held in trust to absorb credit losses over the life of the instrument.
FNMA is currently organizing a road show to tout its version of this product. The structure will be called Connecticut Avenue Securities (CAS is the acronym). These deals are expected to look like CMOs in that they have multiple tranches and variable pricing.
The NCUA is not quite sure what to think of this paper. Last week the NCUA issued a statement that this new risk-asset paper would not be an allowable investment for federally-insured credit unions. This produced a surprised reaction for the self-same credit unions. After all, with FNMA and Freddie shrinking, what are credit unions going to buy instead, if not this kind of asset? In a rare admission that they jumped the gun, the NCUA subsequently rescinded that message and said that investing in this product was allowed. The NCUA did clearly state that it was the responsibility of the investing credit union to fully understand the credit risk in these instruments and be prepared to defend their purchase in upcoming examinations.
The bonds that are being sold in the early going are not rated by a rating agency. They do have enough credit support that they might have been considered low single-A or high BBB rated, but that rating is not being sought. The intent is to structure these like unrated FNMA and Freddie unsecured debt instruments for tax purposes.
This program is just getting started. However, the pressure on the GSEs to shrink their market footprint means that such deals as described above will be the norm for FNMA and Freddie over the coming years. There are all sorts of details to be worked through, but be prepared for a seismic change in what sort of investments will be available to you.