Jack Barnes: The U.S. Federal Reserve only officially sets one interest rate, which is the “discount rate” at which a bank in trouble can borrow from the U.S. central bank. As the Fed itself states:
“The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility–the discount window. The Federal Reserve Banks offer three discount window programs to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. All discount window loans are fully secured.”
The Federal Reserve also explicitly targets the rate for the benchmark Federal Funds that banks charge each other for overnight loans, for money on deposit at the U.S. central bank.
” … Changes in the federal funds rate triggers a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.”
What Your Father Never Told You About Fed Policymaking
These rates are set/targeted by the policymaking Federal Open Market Committee (FOMC), which meets about every six weeks. These two rates, both at the extreme short end of the lending curve, are the baseline for what money should cost in the domestic economy.
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The FOMC is a blend of monetary-system stakeholders. This provides it with a pool of political appointees and a rotating roll of regional presidents.
“The Federal Open Market Committee (FOMC) consists of twelve members–the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.”
The combined group of monetary leaders meets eight times a year and set policy. The policy is communicated to the world via a tightly massaged and scripted press release that the world’s money managers scavenge to see what individual words have changed.
In times past, money managers only had that press release – and the tendency to “overreach,” – or to see what wasn’t there at all – was commonplace. Now, with Chairman Bernanke having held the first press conference on the day of a policymaking meeting in addition to the press release, those same money managers now have YouTube videos of the chairman’s comments to watch over and over again to their hearts’ content – and then read too much into.
There are press releases with zero changes in them, or rather none that are noticeable. In others, rarely, there is an inflection point. These inflection-point press releases establish new central bank policies, which typically will be in place for a year or more.
A change in stance is a rare moment in the markets, and one that can make or break a money manager’s career. These are the important meetings, and the wording of the new press release can drive markets around the world.
The bond market is considered to be “slow money,” in that it does not tend to change direction as a trend very often.
The last time there was a major change in direction by the Fed was in the summer of 2007. That’s when the central bank started a series of emergency cuts in the two afore-mentioned rates – ostensibly to help banks with funding issues to deal with the fallout of the subprime mortgage crisis and its market aftermath.
The Federal Reserve made the first Fed Funds rate cut in September 2007, and by December 2008 had slashed that benchmark from 5.25% all the way down to the afore-mentioned range of 0.00% to 0.25%.
The Fed Funds rate has remained at that level ever since.
The central bank started cutting the discount rate back in August 2007 and continued the decreases throughout 2008. A single increase in early 2010 left the primary discount rate at 0.75%, where it has remained ever since.
Together, this has helped Fed-member banks to raise cash cheaply to cover their funding issues.
But the banks have left these funds on deposit at the Federal Reserve. This has caused a scenario in which no one is loaning money to anyone. In monetary theory, we have a Fed that is pushing on a string, trying to get the economy to grow.
Are the Bond Market’s Biggest Players Playing Musical Chairs?
Lately, very large players in the bond market have been selling into the QE2 primary-open-market-operation events – thus lowering their bond exposure. Two of the largest are the most obvious.
During a recent four-month stretch, China was a net seller of U.S. Treasuries, according to the U.S. government’s Treasury International Capital (TIC) reporting system. At roughly the same time came the news that PIMCO’s Gross had achieved a net-short exposure to U.S. Treasuries.
This leads a market observer to wonder who will be buying U.S. Treasuries when neither the largest international holder, nor the world’s largest mutual fund, is in the market. The answer is that PIMCO’s Gross will, by law, have to start to reverse his position. This makes him a major future buyer of U.S. Treasuries.
But the obvious question is: Just when?
The Fed, which has grown its balance sheet to more than $2.6 trillion from less than $900 billion in 2008, has become the largest buyer and holder of U.S. Treasuries.
The Fed also held about $1.3 trillion in mortgage-backed securities (MBS) purchased during the initial Quantitative Easing foray that the central bank is holding to maturity. These were purchased from large investors, such as the afore-mentioned PIMCO Total Return A Fund (MUTF: PTTAX), which made an obvious bet on the MBS buying before it was announced.
These MBS contracts, pretty much abandoned by Wall Street traders, were sold to the Fed. This transfer of ownership moved the future losses to the central bank balance sheet.
This means that as people refinance or sell a home, the odds are that a good chunk of the proceeds are sent to the Federal Reserve as partial payment for the originating MBS holdings.
This “run off,” as it is called, is pouring billions of dollars per month in fresh capital – in the form of cash – directly onto the Federal Reserve’s balance sheet. The Fed, via its “QE-lite” program, is reinvesting this cash into U.S. Treasuries.
This program is ongoing and will not be affected by the ending of the QE2 program. So, while the market discusses the end of QE2 and the start of QE3 at some point in the future, QE-lite goes on. And that is generating the need for regular purchases of U.S. Treasuries from the open market.
Bonds and Your Investment Portfolio
While the Fed has made it clear that it wants to keep rates low for an extended period, it will not be the 800-pound gorilla in the U.S. Treasury bond market it has been during the QE2 period. This means that the long end of the U.S. Treasury market should start to move up in yield (the bond’s interest payment divided by its price). This shift will be driven by a price drop in these very same bonds.
This is the trade that PIMCO’s Bill Gross is playing. He is supposed to have purchased puts on the U.S. Treasury long end. If so, he is betting on an oversized increase in the long end of the U.S. Treasury yield. This is a very logical outcome to out-of-control spending because of the ever-increasing rollover needs of current debt.
The move at the long end of the bond market – even if it happens quickly – will be telegraphed by the actions taken at PIMCO. As the world’s largest bond manager, this firm helped set the gold standard for bond exposure. When it starts to unwind its short position, the market will know it and telegraph the event.
Bonds are referred to as the “smart money” for a very good reason: In the end, they have a business model built around patience.
Action To Take – From The Editor
Interest rates on Treasury bonds will remain at extraordinarily low levels for months or even years to come. But the prices of those same Treasury bonds will soon take a major dive, driving yields up.
Investors looking to cash in on these higher yields should watch PIMCO and its founder Bill Gross. When the world’s largest mutual fund begins to unwind its short position in Treasury bonds, a slide in prices is on its way.
And when prices fall, be ready to buy in.
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