December 17, 2015
By: David R. Pascale, Jr.- George Smith Partners
The Federal Reserve Open Market Committee voted unanimously to raise the target Fed Funds Rate by 0.25%, ie what the Fed will charge institutions borrowing directly from the Fed. This is a major step in the Fed’s attempt to ‘normalize’ economic conditions.
The markets reacted very positively on the combination of: (1) Fed decisiveness: The Fed effectively communicated the rise and pulled the trigger, markets love certainty and today the Fed delivered that; (2) Fed confidence in the economy: During much of the post-crisis era, markets have reacted favorably to bad economic news as the contrarian mentality held that continuing bad news would keep up the extraordinary measures adopted by the Fed. Today’s rate hike is being seen as an affirmation that the US Economy is in recovery; (3) Future rate hikes will be data dependent, markets focused on one word – gradual. The Fed made it clear that future rate hikes will not be quick and steep.
They issued guidance indicating about 4 quarter point raises per year, which markets are interpreting as about 2-3 raises per year. Contrast that to the last round of ‘normal tightening, which consisted of 17 quarter point hikes from June 2004 to June 2006.
LIBOR/Prime/Treasuries: LIBOR rates are rising as they usually do in step with the Fed rate. This will affect: (1) Existing floating rate loans; (2) Debt Fund Lenders utilizing bank lines based on LIBOR in order to fund their loans (either they will have to raise spreads or accept less profit); (3) Swap spreads (will this start to normalize the swap spread back above the treasury?); Major banks hiked their Prime Rate from 3.25% to 3.50% as expected. Consumers will be affected as banks use this to determine rates on credit cards, auto loans. Housing will also be affected as home mortgage rates will rise. Treasuries: This may lead to a flattening yield curve with shorter treasury yields rising and longer yields staying flat until real inflation rears its head.
Tools: The Fed used to raise rates by raising the Fed Funds rate. But today’s financial system is awash in trillions of dollars of higher liquidity after 7 years of accommodative policy. So the Fed will also experiment with some new tools, including boosting the ‘Reverse Repo Program’. In this program, the Fed borrows money overnight in exchange for Treasuries on their balance sheet. The Fed will raise this rate in order to attempt to drain liquidity from the system, creating a more inflationary and normal environment. This tool will be closely monitored in the next few weeks and possibly tweaked if necessary. This is ‘uncharted territory’ and should be interesting.
Fed Holdings: The Fed’s balance sheet stood at about $900 billion in the ‘normal’ era pre-financial crisis. Since then, the Fed has implemented three rounds of quantitative easing, during which they purchased $80 billion of securities monthly for extended periods of time. (US Treasuries and Mortgage Backed Securities). The Fed balance sheet is now $4.5 trillion. The Fed Chair made it clear today that the Fed will be reinvesting these securities as they mature, over $200 billion will mature in 2016. This is another ‘dovish’ component of the Fed policy and critical to holding 10 and 30 year treasury yields in check. The consensus is that the re-investing of these bonds is worth about 50 bps in lower yield for the 10 year Treasury