Federal Reserve & Interest Rates

Federal Reserve Chairman Ben Bernanke gave a speech today at an annual economic symposium that sends more signals to the market that with inflationary pressures abating somewhat recently interest rates will stay at their current level for some time.

In view of the weakening outlook and the downside risks to growth, the Federal Open Market Committee (FOMC) has maintained a relatively low target for the federal funds rate despite an increase in inflationary pressures. This strategy has been conditioned on our expectation that the prices of oil and other commodities would ultimately stabilize, in part as the result of slowing global growth, and that this outcome, together with well-anchored inflation expectations and increased slack in resource utilization, would foster a return to price stability in the medium run.

In this regard, the recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year.

The price of oil has been quite volatile the last two days, rising $6 on Thursday only to fall another $6 today.  Traders are watching movement of the dollar very carefully which is why we are seeing big swings in the commodities market.

There are also widely varying views on the future movement on the price of oil.  Some analysts are saying crude will be back to the $150 level by the end of the year, while others are predicting that oil will fall to $80 within 12 months.

Oil’s recent slide can be attributed to two dynamics, a strengthening dollar and weakening global demand.  It’s future movement could well depend on how foreign economies fare in the next six months, the worse off they are, the stronger the dollar will be, which is a major driving force of commodities markets at the moment.

In July, the European Central Bank raised interest rates by a quarter percent in order to combat inflation which is averaging at a 4% annual rate.  It’s really an interesting situation, normally if interest rates rise in another country it would put negative pressure on the dollar.

The European Union’s economy already showed signs of shrinking in the second quarter and last month’s rate hike isn’t going to help matters.  So while currency traders might not necessarily be bullish on the greenback they could very well be growing bearish on the Euro which would spell good news for commodity prices and inflationary pressures in this country.

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.