The Fed, interest rates and the recovery How is the Federal Reserve organized? Set up by Congress to regulate monetary policy Control the money supply,

The Fed, interest rates and the recovery

How is the Federal Reserve organized? Set up by Congress to regulate monetary policy Control the money supply, interest rates and inflation 12 Federal reserve districts

New York district is first among equals Fed’s Open Market Committee meets 8 times per

year

How the Fed controls interest rates

Banks hold funds on reserve at the FedThey maintain between 3% and 10% of total savings and checking accountsAt the end of each day, banks borrow from each other or from the Fed to cover reservesThey do this is a private financial marketThey borrow from each other at the Federal Funds rateThey borrow from the Fed at the Federal Discount rate (however this is discouraged and rarely happens)

The Federal Funds Rate

The rate at which banks borrow from each other to cover reservesControlled by the Fed’s Open market CommitteeFed does not directly set this rateInstead, it sets a target rate to be achieved through market forcesIf they want the rate to fall:

Fed buys securities from banks and increases their reserves (increases the money supply)

If they want the rate to rise: Fed sells securities to banks and takes the money

from excess reserves (decreases the money supply)

The Federal Reserve Discount Rate

Rate is directly controlled by the FedChanging this rate surrounds “announcement type” eventsBanks can, but rarely do, borrow at this rate from the FedFed uses this rate to signal changes in monetary policy

Raising the rate indicates a more restrictive policy Lowering the rate indicates an expansive policy of

putting more money into the system

Fed acts to keep the targeted Federal Funds rate and the Discount rate “in synch”

How does the Fed work?

The key interest rates:

March 2002 October 2001

October 2000

Federal Discount Rate

1.25% 2.00% 6.00%

Federal Funds Rate

1.74% 3.63% 6.56%

Prime Rate 4.75% 6.50% 9.50%

90 day T-Bill rate 1.76% 3.29% 6.02%

How does this influence the economy?

When the Fed lowers rates, short –term interest rates typically move lower as wellFor the consumer:

Short term debt Adjustable rate mortgages Automobile loan rates Home equity lines of credit

For a corporation Short-term variable rate debt Leasing rates Possibly, but not necessarily long-term rates as well

Why not necessarily long-term rates?

REMEMBER the Yield Curve!Short term rates are influenced by the FedLong term rates are set by investors and the bond market

Expectations theory – long-term rates reflect anticipated movements in short-term rates over time

If the Yield Curve has an upward slope, indicates anticipated strength in the economy

Higher profits and business activity make it easier to cover debt payments

What about the current economy?

The Yield Curve has a significant upward slope beginning about 6 month out

Anticipation of improved economic environment

The spread between corporate bonds and government bonds is decreasing

This is another indication of an improving economy Spreads are driven by a lender’s expectation of a

borrowers credit quality Ability to re-pay debt Driven by cash flow and earnings As of January, this spread was 4.7%; Still higher than in

the past 5 years, but down from highs of 6% as recent as 4th qtr, 2001

Why is the recovery expected to be weak?

(SOURCES: Wells Capital Management Newsletter, Fortune Magazine, CBS Market-watch)

Remember, stock values are driven by cash flow

Earnings are a proxy for cash flow The investment community pays significant attention

to P/E ratios: A stock’s price per share divided by earnings per share

In order for prices to rise, earning must grow if P/E multiples remain stable

Or Investors must accept higher multiples

What drives a recovery?

Corporate earnings, and the resultant increase in cash flows, must occurCorporate income can increase if:

Sales increase Costs decrease

What could drive an increase in sales?

Pent-up Business demand for capital items such as plant and equipmentPent-up business demand for technology itemsLong-term investment opportunitiesPent up consumer demand for durable goods:

Housing Automobiles Major appliances


Factory utilization is less than 75%, 60% at high-tech companies – unused capacity will be utilized before new capacity addedMany feel technology dollars were spent in preparation for Y2K. Pace of technological innovations has slowed. Markets are flush with almost new equipment from dot.com burnout. Secondary market companies are flourishingMedian S&P 500 technology companies have 25% of assets in cash – dearth of new investment opportunitiesCorporate balance sheets still heavily debt ladenConcern over coming accounting changes – expense options?


US consumption never took a big downturn Low mortgage rates and 0% financing kept housing

and auto sales strong Discount stores have been strongest, i.e., Wal-Mart

and Target

Demand driven by lower costs does not help corporate financials Consumer debt remains at record high levelsJob market uncertain because of continued increases in productivityWill poor 401(k) performance finally hit home?

Other issues affecting the recovery

Big ticket real spending Normally think of nominal numbers being “higher”

than real because of inflation Big ticket spending is now a greater % of real GDP

than nominal GDP, a trend that started in the 90’s but has grown progressively pronounced

This indicates a deflationary environment for big ticket spending

Growth being driven by greater unit sales, but lower prices


Labor market Although GDP indicates a mild recession, overall job

loss (on a gross basis) was the largest ever. Feeling of some is that the jobless rate was helped

along by little or no growth in the labor force As the economy gains steam, the fear is that a

swelling labor force will offset improving economic conditions keeping unemployment close to current levels


Interest Rates Will the Fed have to raise interest rates? Although Long-term yields have fallen slightly of late,

they are still at the same levels they were before the Fed began dropping short-term interest rates


What drives profits - cost reductions or increased sales?

Historically, corporate profits were driven by increases in sales (positive correlation between GDP and corporate profits)

In the 90’s this correlation turned negative – meaning corporate profits were being driven by cost reductions

Around 2000, profits and sales were again positively correlated

If profits are again tied to sales, could limit growth based on earlier issues regarding pent-up demand!


The Bond Market The volatility of corporate bond yields based on standard

deviation is at an all-time high Although the spread between Moody’s investment grade

bonds and 10-Treasury bonds have decreased recently, they remain extremely high

Is this spread the result of a risk premium in the yield curve, suggesting long-term economic uncertainty? Or is it future interest rate expectations?

High quality corporate bonds are becoming an increasingly smaller part of the total value of US Corporate bonds – 55% opposed to 70% at the start of the 90’s and 85% in the early 80’s – make Treasury bonds more attractive?

Historically, the correlation between stock and bond price movements has been negative. When it has turned positive, this has signaled the end of a bull market. Correlations are currently positive!


Stock market drives – Earnings or Increased valuation through higher P/E multiples?

From 1982 through 1992, P/E multiples went from 7.7 to 20.8 From 1992 through 2000, the market was driven by earnings

growth with relatively stable P/E’s (except in the technology sector)

Because P/E’s are at or near record highs, some feel earnings must drive stock prices

According to multexinvestor.com the S&P500 will have real earnings of $45 in 2002. At a high P/E ratio of 25, that results in a year end target of 1125. Today (3/12), the S&P500 is at 1165.

How strong is the earnings outlook? Remember, earnings is tied to sales by virtue of its current

positive correlation

Conclusions!?

Who knows? This is just one take on current conditions!Other analysts will have different opinionsOne thing is certain, its been a long wait since we’ve hit a new high in the S&P 500!This is what makes investing such a challenge!

Documents

The Fed, interest rates and the recovery How is the Federal Reserve organized? Set up by Congress to regulate monetary policy Control the money supply,