Ben Bernanke’s parting shot Yesterday, the Federal Reserve ended its Federal Open Market Committee meeting and decided to taper. It wi...
Ben Bernanke’s parting shot
Yesterday, the Federal Reserve ended its Federal Open Market Committee meeting and decided to taper. It will reduce purchases of Treasuries by $5 billion a month and purchases of mortgage-backed securities by $5 billion a month, which means the Fed will continue to build its balance sheet by $75 billion a month instead of by $85 billion a month. Tapering will begin in January. This was Ben Bernanke’s final FOMC meeting as Chairman before the torch passes to the “dream team” of Janet Yellen and Stanley Fischer. Bernanke’s final press conference was no victory lap, but the press was respectful.At the December FOMC meeting, the Fed released its economic forecasts.
Market reaction
Bonds initially sold off on the news, with the ten-year trading above 2.92. Then bonds rallied, and the yield dropped to 2.82%, and then finally bonds sold off, with the yield ending the day at 2.89%. Stocks loved the report, with the S&P 500 rallying 33 handles to close the day at a record high. Mortgage-backed securities were off by almost half a point.
Is this the first in a series of moves?
Steve Liesman of CNBC asked this question, and it seems that the Fed will reduce asset purchases by something like $10 billion every meeting from now on. Bernanke mentioned all of the caveats about being data-dependent, but it looks like this will be a constant until the Fed is no longer purchasing assets. The Fed will continue to reinvest maturing proceeds back into asset purchases. Ben Bernanke stressed that the Fed’s balance sheet is still growing, but it just isn’t growing as fast as it was. Bernanke was asked if that meant the Fed would likely still be conducting asset purchases in mid-2014 (as was the previous guidance), and he said QE would probably end in late 2014.
The Fed eases the pain a little
The Fed changed the language regarding how long rates would remain close to zero. Previously, the Fed had guided an unemployment target of 6.5% as the level it would start raising interest rates at. That language was changed to, “The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds ratewell past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.” That language was what the stock market focused on, and it probably accounts for the rally.
Implications for homebuilders
For homebuilders like Lennar (LEN), KB Home (KBH), Standard Pacific (SPF), PulteGroup (PHM) and Toll Brothers (TOL), this means that mortgage rates are going to rise. As mortgage applications continue to fall (today the Mortgage Bankers Association Mortgage Applications Index dropped to its lowest level since 2001) the Fed’s footprint in the TBA market got bigger and bigger. It made sense to lower the Fed’s impact on the MBS market.
Rising mortgage rates are not helpful for the builders, but they’re not the only thing that matters. As the economy improves, they will get increased traffic as people’s financial situations get better. We recently saw that household net worth increased by something like $1.9 trillion over the past quarter. This will matter much more to the builders than 30 or 40 basis points on the 30-year fixed-rate mortgage.
Usually at the March, June, September, and December FOMC (Federal Open Market Committee) meetings, the Fed releases its economic forecast for the current year and the upcoming two years. One of the nice things about this is that you can see how its forecast has changed over time. In this part of this series, we’ll look at its unemployment forecast for 2013, 2014, 2015, and 2016, and also at how its forecast for 2014 unemployment has changed over the past few meetings.
The Fed has been taking down its unemployment numbers for 2014
As you can see from the chart above, since its December 2012 meeting, the Fed has been lowering its estimates for 2014 unemployment. At the December 2012 meeting, the Fed was forecasting that 2014 unemployment would range from 6.8% to 7.3%. Wednesday, it was anticipating that it would come in between 6.3% and 6.6%. The problem for the Fed is that the unemployment rate has been falling for the wrong reasons—it has been falling because the labor force participation rate has been falling. The latest labor force participation rate of 63% was the lowest since the late 1970s. If unemployment is shrinking only because the labor force is shrinking, then that isn’t a sign of economic strength. During the press conference, Bernanke was asked directly about the labor force participation rate, and he acknowledged that the unemployment guidance was meant to be taken holistically. He further said that if unemployment dropped to the 6.5% threshold, the Fed would begin to look at the other important numbers (labor force participation rate, employment-to-population ratio, hires, fires, et cetera) before making any decisions on interest rates. This is an implicit acknowledgement that the headline unemployment number understates some of the real issues in the labor market.
Implications for homebuilders
For the builders, this meeting helped reduce mortgage rates, which is welcome news to the builders. As several have noticed, especially among the builders at lower price points, the first-time homebuyer is stepping away from the market. Between having to compete with professional investors for starter homes, struggling under large student loan debt, and a lousy job market, the first-time homebuyer just can’t catch a break. The builders facing the brunt of that trend are PulteGroup (PHM), Beazer (BZH), and Standard Pacific (SPF). The builders at the high end, like Toll Brothers (TOL) and Meritage (MTH), are more insulated. Still, lower unemployment is better for the builders than high unemployment, even if unemployment is down for the wrong reasons.
At the December FOMC meeting, the Fed released its economic forecasts
Usually at the March, June, September, and December FOMC (Federal Open Market Committee) meetings, the Fed releases its economic forecast for the current year and the upcoming two years. One of the nice things about this is that you can see how its forecast has changed over time. In this part of this series, we’ll look at its GDP (gross domestic product) forecast for 2013, 2014, 2015, and 2016, and also at how its forecast for 2014 GDP growth has changed over the past few meetings.
The Fed had been taking down its GDP growth estimates for 2014
As you can see from the chart above, since its December 2012 meeting, the Fed has been lowering its estimates for 2014 GDP growth. At the December 2012 meeting, the Fed was forecasting that 2013 GDP growth would range from 3.0% to 3.5%. At the last meeting, that dropped to between 2.8% and 3.2%. Ever since the crisis, the Fed has been consistently high in its GDP forecasts. In many ways, the Fed has been modeling this recession like a garden-variety recession driven by high inventory. Most recessions over the past 50 years have been inventory-driven and have been caused by Fed tightening. Usually the sequence goes like this:
- The economy expands
- Inflation starts to be felt
- The Fed raises interest rates
- Consumers stop spending
- Inventory builds
- Companies lay off workers
- Inventory works off
- Companies re-hire workers
- The cycle begins again
The net effect of these types of recession is that they’re usually short-lived and the recoveries from them are swift. This is why the Fed has been forecasting 3%-plus growth since 2009. This recession was fundamentally different in that it’s similar to the Great Depression because it wasn’t caused by Fed tightening—it was caused by a burst asset bubble. And these recessions are much more intractable and impervious to government stimulus. In these recessions, the buildup is not of inventory, but of debt. And debt takes a lot longer to work off than inventory. Also, when consumption is 70% of the economy and it’s depressed by consumer de-leveraging, you don’t get the spending needed to pull the economy out of its slow growth pattern. This is why this recovery has been so unsatisfying.
Implications for mortgage REITs
The agency REIT ETF (MORT) was up on the FOMC statement, but it underperformed the market. The agency REITs like Annaly (NLY) and American Capital Agency (AGNC) benefit most from Fed stimulus. It lowers their cost of funds and boosts the value of their holdings. If you think we’ll be in a slow growth environment, where the Fed will have to increase asset purchases to stimulate the economy, the long-duration agency REITs are where you want to be. If you think the economy will slowly improve but do nothing spectacular and that interest rates will slowly increase, you probably want to be in adjustable-rate agency REITs like MFA Financial (MFA) and Hatteras (HTS), as you get the upside of higher rates in your portfolio and lower duration. If you think the economy is about to take off, then you want non-agency REITs like Two Harbors (TWO), so you get the benefit of improving credit exposure.
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