MarketView for September 23

 

 

Summary  

  

The Federal Reserve kept interest rates unchanged, as expected, but it also said it would slow purchases of mortgage debt to extend that program's life until the end of March. That was seen as a step toward a measured withdrawal of its extraordinary support for the economy during the downturn. As a result, stock prices rallied and then fell sharply, sending all three major equity indexes into negative territory over concerns that the extraordinary funding designed to shore up the economy is coming to an end. Among the key casualties were banks, housing stocks and energy shares.

 

Initially stocks had risen sharply following the Fed's comment that economic activity was picking up, but in the last hour of trading the market reversed course over concern that the timing of the removal of some of the Fed's stimulus could be premature. The other was the Fed's stated intent that interest rates will stay low for an extended time, which means lower income for banks. As a result, JPMorgan fell 3.03 percent to $45.06, making the stock the Dow's top drag.

 

Toll Brothers fell 3.4 percent to $20.68, while Chevron closed down 1.7 percent at $71.73. Cisco Systems weighed heavily on Nasdaq, falling 2.6 percent to $22.80.

 

Fed Says Economy Improving

 

The Federal Reserve stated after its meeting that the economy was in recovery after a severe downturn and that it had decided to slow purchases of mortgage debt to extend that program's life until the end of next March. The Fed, as widely expected, held overnight lending rates at close to zero percent and repeated its intention to keep rates exceptionally low for an extended period.

 

"Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn," the Fed said a statement.

 

The Fed said that it would gradually slow the pace of its purchases of mortgage-related debt in order to promote a smooth transition in markets, but reiterated it would keep its options open.

 

"The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook," it said.

 

The Fed doubled the size of its balance sheet to around $2 trillion as it flooded financial markets with money during the crisis last year. It has maintained this support through a campaign to buy $300 billion of longer-dated U.S. government bonds and $1.45 trillion of mortgage-related debt in an effort to keep lending rates low.

 

The Fed opted in August to taper down the Treasury purchases by the end of October, and had been expected to opt for a similar gradual withdrawal for its mortgage debt buying, which initially had been scheduled to close at year-end.

 

Recent data has pointed to turnarounds in manufacturing, housing markets and consumer sentiment, and many analysts expect strong growth in the third quarter after four quarters of contraction. However, with unemployment at a 26-year high of 9.7 percent, most analysts nevertheless expect consumer spending to remain weak and damp the recovery.

 

Geithner Argues For Watchdog Agency

 

Treasury Secretary Timothy Geithner argued forcefully on Wednesday for creating a government watchdog for financial consumers, while giving cautious support to paring back its scope. Amid stiff resistance by banks and Republicans to the proposed Consumer Financial Protection Agency, Geithner told a House of Representatives committee the CFPA is needed to fix failures starkly revealed in the global financial crisis.

 

"The need for a dedicated, consolidated consumer protection agency is clear. The current consumer protection system failed," he told the House Financial Services Committee.

 

The CFPA would be a central consumer protection overseer handling laws now vested in several existing agencies, including the Federal Reserve, which have been criticized widely for their past performance.

 

Committee Chairman Barney Frank said existing regulators' record on consumer protection is "abysmal."

 

But critics have said the CFPA would only tangle businesses in more government red-tape at greater cost to taxpayers.

 

The CFPA is the next piece of President Barack Obama's complex financial reform puzzle to gain headway in Congress. Credit card reform has been accomplished and a restructuring of the troubled student loan market is close to Senate consideration, having already won House approval.

 

Other, more difficult pieces still await action, such as creating a systemic risk regulator, finding new ways to deal with failing financial firms, and regulating other areas of the financial world that last year ran off the rails.

 

Obama said on Wednesday that financial regulation needs strengthening to end the "greed, excess and abuse" that caused the financial crisis that began late last year, slamming the brakes on economic growth around the world.

 

Lawmakers have also debated whether the CFPA should be able to both write and enforce consumer protection rules. Geithner said separating those powers "would risk creating an agency that is weak and ill-informed."

 

The hearing marked an intense push in coming weeks by the committee on financial reform. Frank said he expects a House vote on legislation in November.

 

Mortgage Applications Rise

 

Mortgage applications rose sharply last week to their highest point since late May as interest rates fell below 5 percent, data from the Mortgage Bankers Association indicated. The MBA said its seasonally adjusted index of mortgage applications, which includes both purchase and refinance loans, for the week to September 18 increased 12.8 percent to 668.5, the highest since the week ended May 22.

 

Borrowing costs on 30-year fixed-rate mortgages, excluding fees, averaged 4.97 percent, down 0.11 percentage point from the prior week and the first time since the week to May 22 the rate on this most widely used home loan was below 5 percent.

 

However, the rate remained above the all-time low of 4.61 percent set in the week ended March 27. The survey has been conducted weekly since 1990. Nevertheless, interest rates were well below year-ago levels of 6.08 percent.

 

The U.S. government has embarked on an aggressive plan to bring mortgage rates down to levels that would spur demand and help the battered housing market to begin to recover.

 

The Federal Reserve has set a goal to buy up to $1.25 trillion of agency MBS, $300 billion of Treasuries and $200 billion of agency debt in 2009. The Fed expects to have bought all the Treasuries by end-October while purchases of agency MBS and agency debt are due to be completed by year-end.

 

Low mortgage rates, high affordability and an $8,000 tax credit for first-time home buyers, part of the government's stimulus bill, have helped stabilize the market. However, with the tax credit set to end on November 30 and distressed properties making up a high proportion of sales, there is some uncertainty as to the long-term outlook.

 

The MBA's seasonally adjusted purchase index rose 5.6 percent to 288.3, driven by applications for government-insured loans. The government purchase index was at the highest level ever recorded in the survey and the share of purchase applications that were government-insured was 45.7 percent, the highest share since November 1990, the MBA said.

 

The four-week moving average of mortgage applications, which smoothes the volatile weekly figures, was up 4.3 percent. The MBA's seasonally adjusted index of refinancing applications increased 17.4 percent to 2,881.5, its highest since the week ended May 29.

 

The refinance share of applications increased to 63.8 percent from 61.0 percent the previous week, but remained significantly lower than the peak of 85.3 percent in the week to January 9. The adjustable-rate mortgage share of activity increased to 6.7 percent, up from 6.0 percent the prior week.

 

Treasury Issues Debt Equaling $7 Trillion

 

The Treasury will have issued $7 trillion in bonds by the time the current fiscal year ends next week, but it expects the debt increase to stabilize by mid 2010. Although both the markets and the economy are improving, efforts to provide a firm foundation for recovery will require increases to the Treasury's conventional bonds going forward, as well as debt securities that are indexed to inflation.

 

However, this expansion may take place in an environment where investors consider leaving the safe-haven Treasury market for riskier assets, and debt issuance is likely to level off mid next year, said Treasury Acting Assistant Secretary for Financial Markets Karthik Ramanathan.

 

"In fiscal year 2009, which ends next week, Treasury will have issued $7 trillion in gross issuance -- that's in a 12-month period," Ramanathan said. "This issuance was necessary to meet nearly $1.7 trillion in net marketable borrowing needs, nearly $1 trillion more than what we raised last year," he added.

 

The heavily-indebted U.S. government has seen tremendous demand for Treasury debt securities this year due to a flight-to-quality into the safe haven assets.

 

However, Ramanathan said some of this demand would begin to taper off and investors were likely to favor other sectors as the financial markets recovery continues.

 

"Rather than being discouraged by this move to more risky assets we should actually be encouraged," he said. "It is the natural progression from the state we were in last year."

 

There is still a long way to go toward market and economic stabilization but good progress is taking place, Ramanathan said, adding that officials were no longer focused "on LIBOR/OIS spreads on a daily or hourly basis."

The LIBOR/OIS spread is a market measure that reflects the difference between the overnight indexed swap (OIS) rate or the cost of so-called risk-free borrowing, such as that done by the Treasury, and lending to the private sector, which is normally considered less safe. The index is typically an interest rate considered less risky than the corresponding interbank rate. In the United States, OIS rates are calculated by reference to daily Fed funds rates.

When asked whether the Treasury would consider offering a longer maturity bond in the future, Ramanathan said, "We are content with our current suite of securities." The Treasury's longest maturity is the 30-year bond.

 

However, issuance will increase in the near term, as has been the case all year. "Going forward we expect to increase both nominal and inflation indexed coupon issuance incrementally and gradually over the next nine months to extend the average maturity of the debt," he said.

 

Due to structural changes in the budget deficit, Ramanathan said he expected the average maturity of the debt to stabilize at six to seven years, exceeding historic averages of five years. However, he said he expected coupon debt securities, or the bonds Treasury issues, to stabilize next summer and potentially go down toward the end of next year.