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Highlights and Analysis from the Latest FOMC Meeting

You are reading Taylor Advisors’ first e-Brief publication.  Our objective with this electronic newsletter is to continue bringing our clients pertinent industry information without overwhelming the Inbox with countless economic statistics.  Our first article provides a summary and the market’s reaction to the most recent FOMC meeting.  Additionally, we provide a conclusion of how these market events affect various strategies at our financial institution clients.

For the first time since March 2009, the Federal Open Market Committee (FOMC) has decided to take action to promote an easier monetary policy.  At its most recent meeting on August 10, 2010, the FOMC announced that it will not only keep the Federal Funds rate at “exceptionally low levels for an extended period”, but that it will also be investing in U.S. Treasuries in an attempt to boost the economy.  The importance of this decision is that the FOMC will maintain the Federal Reserve’s balance sheet at its present size of just over $2.3 trillion by taking its maturing agency debt and mortgage backed securities and reinvesting them into Treasuries.  It was previously believed that the Fed would try to shrink its portfolio, which grew from $800 billion to nearly $2.4 trillion during the financial crisis.

Currently, the Federal Reserve’s portfolio consists of approximately $1 trillion of agency debt and mortgage backed securities.  For the most part, these will mature faster than the Fed’s Treasury holdings, which is why they will be able to consistently reinvest in U.S. Treasuries.  It is estimated that roughly $10-20 billion of maturing securities will be reinvested each month, which means that up to of $240 billion stands to be reinvested within the next year.  The Fed intends to purchase Treasuries with maturities ranging from 2-10 years.

The desired effect of buying Treasuries is twofold: one is to increase liquidity and lending by adding to the amount of money in the economy and the other is to help lower interest rates.  By reinvesting its maturing mortgages and agency bonds into Treasuries, the FOMC will increase the demand for Treasuries, thus raising their prices and lowering their yields.  This, in turn, will help to lower other interest rates (including mortgage rates) that are tied to benchmarks such as the 10 Year Treasury note.  This may help to fuel to the recovery, which the Fed has now said is “more modest” than they had expected.

Not surprisingly, the FOMC’s announcement drew mixed reactions.  Some economists believe that this quantitative easing could lead to inflation several years down the road or that buying treasuries instead of mortgages could harm a recovery in the housing market.  Others simply think that reinvesting $10-20 billion per month in Treasuries simply is not enough to make a considerable impact on the economy.  However, one can also look at it as a sign that the Federal Reserve is ready to step in and help ensure that the economy, which is still struggling with a high unemployment rate and decreased lending by banks, does not fall back into recession.  Almost immediately after the new policy announcement, the yield on the 10 Year Treasury note fell to 2.779% from 2.818%, its lowest level in nearly 18 months.

Conclusion:  With the Fed’s recent announcement, the market’s expectations of a rate increase have been pushed out to the second half 2011.  Therefore, the cost of excess liquidity will continue to remain high.  Deposit rates in most markets continue to be elevated relative to most wholesale funding benchmarks.

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