Federal Reserve & Interest Rates

Investors are demanding an increasingly higher premium over Treasury yields as spreads on investment grade bonds have widened recently.  If spreads stay this wide, it will be more expensive for many corporate and government entities to raise capital through bond issues.

The gap climbed 3 basis points to a record 311 basis points today, according to Merrill Lynch & Co.’s U.S. Corporate Master index. It was the third time the spread reached a new high this week, surpassing the gap of 305 basis points set March 20, just after the government brokered a takeover of Bear Stearns Cos.

During the current credit crisis financial firms have scrambled to raise hundreds of billions of dollars in capital to cope with the half a trillion in writedowns they’ve taken since last fall.  The continuing weakness in credit and housing markets have many investors predicting that the Fed will keep interest rates at 2% at least until the end of the year.

You have some analysts saying the housing slump could continue well into 2010 if not longer.  Home prices are expected to fall another 15%-20% before it’s all said and done.

Right now the problems in both sectors are feeding off each other.  Defaults and foreclosures are causing more writedowns, while weak credit conditions have caused mortgage rates to rise and is making it difficult for prospective home buyers to enter the market.

Just last week American Express issued 5-year notes at close to junk bond levels despite it’s relatively high credit rating.  You’re seeing spreads rise this high because realistically no one know how close we are to the actual bottom.

The settlement brokered by New York Attorney General Andrew Cuomo with investment banks to buyback billions in auction rate securities will only help a fraction of the investors that bought into the trouble market.

The deals so far announced total about $56 billion of the auction-rate securities market — but there are $210 billion of such securities unredeemed, according to research firm Restricted Stock Partners.

Basically unless you were a client of one the brokers running the auctions you could be out of luck.  Investors that bought from discount brokerages could be stuck holding the bag, since their brokers had no knowledge of the breakdown in the auction rate market and for the most part have not been considered liable.

The investment banks that underwrite the actual auctions are only agreeing to take care of their own clients and even then there are still some gray areas.  Short of legal action it will be unlikely the majority of investors will see any of their money anytime soon.

With investment banks desperate for capital they will probably fight tooth and nail to buyback as little as possible.  However, these investments aren’t really in danger of failing, as much of it is made up of relatively safe municipal bonds.

The sticking point and the crux of the government’s argument with investment banks is that auction rate securities are in actuality long term investments but they were marketed as “like cash”.  Interest rates reset on the securities usually every 7 or 28 days so that investors were able to quickly get into and out of the market until auctions started to fail back in February.

Yesterday the Labor Department released  it’s Consumer Price Index numbers for July which were higher than economists  had forecast.

On a seasonally adjusted basis, the CPI-U advanced 0.8 percent in July, following a 1.1 percent increase in June.  The index for energy rose sharply for the third straight month, increasing 4.0 percent in July and accounting for about half of the overall increase in the all items index.

The food index rose 0.9 percent in July after rising 0.8 percent in June.  The index for all items less food and energy increased 0.3 percent in July, the second straight such increase.

The previous three months saw energy prices rise significantly, 4.4% in May and 6.6% in June to go along with the 4% from last month.  However, in the second half of July the price of oil started to fall with other commodities following soon after.

Unless oil starts to rise sharply again in the last half of August, next month’s index for energy should fall considerably.  One things for sure, there are a lot of people at the Fed breathing a little easier these days.

Global economies are growing weaker, which has spurred demand for the dollar.  That’s been the main impetus for the recent sell off in commodities.

The U.S. economy is also still very weak though, especially the housing and credit markets.  However, there isn’t that great fear anymore of the kind of stagflation we saw back in the 70’s.

Much has been said about how the U.S. is further along the economic cycle than the rest of the world but I guess that just means we’re a little closer to the bottom than everybody else.