The Fed gets serious

Anyone who has doubted the Federal Reserve’s resolve to get the credit markets and the economy moving again need only read today’s statement to become a believer. While some will question how quickly these efforts will jumpstart the economy, there should be little doubt that they will eventually bear fruit. The Fed’s moves today were stimulated by ongoing tightness in the credit markets, economic weakness, job losses and falling home and stock prices.

As expected, the Fed left short-term interest rates at historic lows near 0%. What was unexpected, however, and which galvanized both the stock and bond markets today, was their announcement that they would buy up to $300 billion of longer-term US Treasuries, and more than double their purchases of mortgage-backed securities up to $1.45 trillion. This “quantitative easing,” which the Fed last employed in the 1940’s, is designed to lower long-term interest rates, particularly mortgage rates. The Bank of England recently began a similar program with their own government bonds, and have succeeded in lowering long-term rates in the UK by 0.75%.

So we know from the Fed’s last foray into quantitative easing, and today’s experience in the UK, that it can work, and work quickly. In the 1940’s, the Fed targeted a 10-year yield of 2.5%, and these rates never went above that level for a decade. They were able to do so by holding only about 7% of outstanding Treasury notes and bonds, which today would amount to about $280 billion. So despite what some economists are saying, $300 billion should be sufficient, at least initially, to keep rates down. And today’s market reaction supports that: 10-year Treasury yields plummeted from 2.95% to 2.53%, the biggest 1-day drop in 47 years. Although the Fed has not stated a target interest rate, 2.5% seems to be what the market is betting on.

Lower long-term Treasury rates will translate into lower borrowing costs across the board, from corporations to municipalities to individuals. Even the US government will save money on interest expense. Lower rates, provided borrowers can obtain credit in the first place (a problem which other Fed and Treasury programs are targeting), provide an obvious benefit to the economy.

But the Fed did not stop there. It is simultaneously buying up to $1.45 trillion in mortgage-backed securities, in an attempt to further lower mortgage rates relative to other long-term debt. This represents about 12% of all outstanding mortgage debt in the US, and over 25% of debt guaranteed by Fannie and Freddie. I think there’s little question that taking this much debt off the market will substantially lower mortgage rates, and I suspect that 4% mortgages will become relatively common within the next few months.

Those of you contemplating a home purchase or refinancing should therefore wait a bit until making the plunge. I’ll be keeping a close eye on mortgage rates as well, and will let you know when I think they have bottomed. Note that in the past, the Fed was able to keep interest rates low for more than 10-years; thus I don’t expect rates to rise much until the economy is clearly on the mend.

The path to recovery will not be smooth, and there will be more pain and bad news to come. The current stock market rally, while it may continue for some time and potentially be very powerful, will undoubtedly be interrupted by some scary drops. And although March 9 may have set the final lows for this bear market, it is possible that they will be revisited or even violated somewhat before the new bull market is finally underway.

Fortunately, in addition to the Fed’s obvious resolve, there have been indications that the rate of financial and economic decline may be abating, which would likely precede a definitive turn upward. Housing starts were better than expected, as were retail sales. Commodity prices are rising (copper is up 22% in the past 30 days, oil up 31%). Oracle’s earnings came out better than anticipated, and they instituted a dividend for the first time (in contrast to many other companies that are reducing or eliminating theirs).

But perhaps most significantly, mergers and acquisitions (M&A) are seriously heating up. In the past few days alone, we’ve had several multi-billion dollar acquisition announcements: Pfizer buying Wyeth, Roche buying the rest of Genentech, and today, IBM buying Sun Computer. Big corporations have many $billions in cash looking for a higher-return home, and credit is again flowing to investment-grade companies. Many companies are selling at prices not seen for decades, and cash-rich firms are increasingly deciding that it’s safe to jump into the M&A fray.

Expect many more deals over the coming months and years. And keep in mind that much of the bull market of the 1980’s was driven by merger activity, at a time when companies had less cash and interest rates were far higher. Paradoxically, it is possible we will see a higher stock market in the face of a prolonged recession as stronger companies gobble up weaker ones. It will be fascinating to see how all this plays out; we certainly do live in interesting, if painful, times.

In future emails, I will expand further on how the Federal Reserve’s actions are likely to stimulate the economy. And I will give some detail on how I plan to position portfolios going forward, given all that’s happened and is likely to happen. We are clearly at an inflection point in economic history, one that will be written about for decades. It’s obviously crucial to prepare for the future based on the best information and reasoning one can muster, even if, in the end, the future is unknowable.