Federal Reserve & Interest Rates

The Federal Reserve announced that it was leaving interest rates unchanged in an FOMC statement released today.  It is likely that the Fed will keep rates at their current level as long as inflation expectations remain muted and the economy continues to contract.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

It will be interesting to see if the Fed will have to ramp up it’s balance sheet operation to keep mortgage and other consumer lending rates at their current low levels, once the government starts selling more and more of it’s massive debt that it has accumulated in order to fix the financial system.  There are concerns from some circles that yields could rise significantly once more and more Treasuries start flooding the market.

As for the banking system, initial signs show that it has enough capital to weather the storm, when the Fed released the criteria for the stress test being conducted on the nation’s 19 largest banks.  But with more losses expected down the pipe, is mere survival enough to turn around a credit system that has been floundering since the Lehman collapse.

In a perfect world the government would love to see the banking sector fully recover and use it’s credit resources to fuel a recovery but as long as capital is being held back to cover future losses, that’s just more money that isn’t being lent to the consumer.  It has also become apparent that the government is in favor of the current strategy of converting capital into equity in order to make what’s left in TARP go farther.

It would come as no surprise to me, if the Fed starts to release more money into the system later in the year if inflation remains muted, in an effort to spur growth, although a lot will depend on how markets react to the increased supply of Treasuries.  Until the current economic outlook changes however, you can expect a fairly high demand for Treasuries for some time.

The last two remaining independent investment banks, Morgan Stanley and Goldman Sachs have seen the writing on the wall and have applied to the Federal Reserve in order to convert into commercial banking institutions.

The Wall Street that shaped the financial world for two decades ended last night, when Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.

The Federal Reserve’s approval of their bid to become banks ends the ascendancy of the securities firms, 75 years after Congress separated them from deposit-taking lenders, and caps weeks of chaos that sent Lehman Brothers Holdings Inc. into bankruptcy and led to the rushed sale of Merrill Lynch & Co. to Bank of America Corp.

The big issue is the ability to raise capital by the cheapest means possible and right now that is by taking on deposits.  Investment banks normal method of raising capital, selling bonds has become very expensive, the bond market has been chaotic ever since bond insurers had their credit rating downgraded which sent interest rates upwards across the board.

Another method of raising capital is to sell equity but that is never popular with shareholders since it reduces the value of their existing stakes.  Morgan Stanley had agreed to sell a 20% stake to Mitsubishi UFJ Financial Group Inc. for about $8.4 billion when it was unable to find a U.S. bank to merge with.

A big change for the two companies is that it will now be regulated by the Federal Reserve instead of the Securities and Exchange Commission.  Another big change will be that they will now fall under U.S. deposit laws which will most likely lead to less risk taking by both companies.

Although the change will provide the two companies with much more long term security it may also mean lower profits.  Despite the upheaval of financial markets over the past year, both companies were still able to report positive net earnings although greatly reduced from previous years.

The positive to take out of all of this is that both companies are well placed to become powerful commercial banking institutions.

The shrinking volume in secondary bond markets is making the market more illiquid which has investors demanding higher yields.  These higher yields force companies to pay out comparable rates for new issues, making raising capital a more expensive proposition.

Trading in the corporate bond market has fallen a third after averaging $26 billion a day in the first eight months of 2007, according to Federal Reserve data on primary dealers.

While corporate-bond trading is shrinking, average daily trading in government securities has risen to about $584 billion this year from $560 billion in the same period of 2007, Fed data show.

The increase in Treasury investment has forced it’s yields down, widening the gap between AAA rated debt and government securities of similar maturities.  AAA rated corporations are having to sell new bonds as if they were rated much lower as investors demand higher premiums due to their inability to quickly sell them in secondary markets.

A major reason for the lack of liquidity in bond markets in general has been the fate of the bond insurance industry.  The collapse of their credit ratings has put a big monkey wrench in the smooth running operation of bond markets especially in the municipal sector.

There is a lack of trust in credit markets right now and the Fed’s efforts at pumping hundreds of billions in liquidity haven’t had their desired effects.  Investors don’t trust credit ratings on securities, lenders don’t trust their borrowers and until that changes the credit markets will continue to seize up.