All eyes are on the Fed now. At 2 PM tomorrow, the Board of Governors of the Federal Reserve Bank will announce their decision on the Fed’s bond buying programs. This is likely to be the last significant announcement made by the outgoing Fed chief, Ben Bernanke.
Over the past two days, we have already seen that the fate of the markets is almost wholly tied to the Fed’s mood. With the withdrawal of Larry Summers’ (a known hawk and maverick) nomination for the Governor’s role, the field is now open for Janet Yellen (a known dove).
At the height of the financial crisis when extreme credit market circumstances led to the sale of Bear Stearns to JP Morgan (NYSE: JPM) and the Lehman Brothers went bankrupt — which still remains the largest ever bankruptcy in the US —the government and the Federal Reserve had to go beyond a Zero-Interest Rate Paradigm (ZIRP). According to Okun’s law, for every 1% rise in unemployment, a country’s GDP growth rate will roughly fall by 2%. We also know from the Phillips Curve that higher inflation will lead to lower unemployment. To increase inflation, the strongest tool that the Federal Reserve Bank has is interest rates. To that end, the Fed reduced the target interest rate to zero in December 2008. However, as the crisis spiraled out of control and unemployment touched 10%, the Fed resorted to buying bonds in the open market – both MBS and US Treasuries — a move known as quantitative easing (QE).
QE inflated the Fed’s balance sheet to unprecedented levels and helped the US economy get out of the worst recession it has faced since the Great Depression. While the short-term funding programs that were needed during the height of the crisis are mostly wrapped up, the Federal Reserve has inflated its assets from a near static $800 billion (since 2003) to $2.5 trillion (end-2007) to the current level of $3.66 trillion. Double-dip recession was thus, avoided and which, in turn, led to the current record highs in the equity markets.. Consequently, all eyes are now on the Fed. Fundamentals are assuredly improving and we expect the Fed will begin tapering its bond buying (especially that of MBS). Analysts predict a $5 billion reduction; traders expect $10 billion, while we forecast that it will be in the $10 – $15 billion range. If any less, the markets will be elated and stocks will shoot up. If more than the $15 billion mark, there will be short-term mayhem.
In our opinion, the tapering is a non-event at this point. Given the jobless recovery and the very low inflation rates, the rationale for the cut seems a political rather than economic move.
So, where is the trade in this news? We believe that the cuts will come from the Mortgage Backed Securities (MBS) buying program – and thus, there will be an immediate effect on mortgage rates. Homebuilders, who are already under pressure, will face additional hits on their revenues. Stocks of companies like Toll Brothers Inc. (NYSE: TOL) and KB Home (NYSE: KBH) are both trading close to 40 PE. Toll with its 2.44 P/Sales and KBH with a 3.94 P/BV are likely to face significant stress.