Chris von Keitz VP of Trading Analysis: The Fed’s Large-Scale Asset Purchases Explained

After news of a strong bullish market push to close out Wednesday’s (2/27) trading session, it is important for our readers/club members to understand the fundamental driving force behind this push. Below is a chart and headline from CNN Money, which I explain in the paragraphs immediately following them.

- The Fed effectively helped the DJIA rally to a new 5-year high -

NEW YORK (CNNMoney Headline)

A rally on Wall Street gained momentum late Wednesday as investors welcomed more upbeat housing data and a second day of dovish testimony from the chairman of the Federal Reserve.

http://money.cnn.com/2013/02/27/investing/stocks-markets/index.html?iid=HP_LN#sthash.4RP3isrU.dpuf
 

Analysis of reasons for this Rally

The United States Federal Reserve (Fed) traditionally oversees monetary policy through the manipulation of interest rates. But following the 2008 economic slowdown and interest rates for the federal funds rate (“the interest rate that depository institutions charge each other for borrowing funds overnight”) being set nearly to 0%, the Fed in 2008 turned to a new method to spur on economic growth: large-scale asset purchases (LSAP), which in the Quantitative Easing 3 (QE3) strategy for the first time was announced without a set date of termination.
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What are these ‘LSAP’ purchases, how are they executed, and what do they do?
‘LSAP’ purchases are made by the Fed by buying long-term securities from the US government and longer-term securities “issued or guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac.” It’s important to note the these purchases are made (or executed) through the private market as opposed to buying them straight from the Treasury such as at www.treasurydirect.gov. This is done to achieve a result predicted by simple economics; as the supply of the bought securities decrease due to the Fed buying them, the demand (and thus price) for the remaining ones increases which results in lower yield rates. This, in turn, means lower mortgage interest rates, because low yield rates on mortgage-backed securities directly cause them to decrease. The ‘upbeat housing data’ mentioned in the CNN Money article above  is largely explained by these economic interactions.
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But what about Private Investors looking for high yield investments?
As the yield rates decrease due the Fed’s purchases of US Treasury Securities and agency-guaranteed mortgage backed securities, private investors turn to high-yield investments. These are offered mainly via corporate bonds and privately issued securities. However, as investors turn to these alternatives their demand increases as well directly causing yield rates to decrease.
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So what is the ultimate goal and reason behind the Fed’s LSAP Q3 program?
After reviewing the information outlined above, the overall goal of the Fed is to decrease the yield rates on several long-term securities, strengthen the housing/mortgage market, and thus create increased economic prosperity. A key aspect of QE3 is the Fed did not announce a set end date to their program. That’s with recent rumors circulating Monday and Tuesday that the Fed might end it’s LSAP program sent the market into a dip. However, Ben Bernanke issued a statement of the continued support of LSAP programs utilized by the Fed, which strongly boosted the Markets in the last half of the main trading period.
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Critique about the Fed’s LSAP and other programs
As Fidelity’s weekly market updates for the week of February 22nd put it, “investors, who expected QE3 to continue until a recovery was more evident, were caught off guard [by rumors of ending LSAPs]. The global economy is not prepared for a world without the large-scale intervention from the Fed and other central banks, they argue, and the U.S. recovery would slow substantially” (Fidelity). Additional concerns have been raised about the Fed’s balance sheet, which has tripled in size since 2006.
 
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Fed Balance Sheet, 2006 to Present, $trillions:
 
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Currently the Fed purchases $45bn of long-term US Treasury Securities and $40bn of agency-backed mortgage securities from the private market per month. As a direct result, "banks are then able to lend out the proceeds of these asset sales as they fit" because the Fed injected capital into the banks and increased their liquidity (Fidelity). But a main counter point of critics is that while these programs increase the banks willingness to lend funds (due to increased supply) there is no demand for them from business nor customers. The Fed, however, seems unaltered by these claims and as seen by the markets' wild swings in the past 3 days mainly due to QE3, it is evident the economy is still largely dependent on the Fed's actions to maintain its current growth.
 
 
Sources:
  1. http://www.federalreserve.gov/faqs/what-are-the-federal-reserves-large-scale-asset-purchases.htm

This Article was published and written by VP of Trading Research Chris von Keitz on 2/27/13

LinkedIn: http://www.linkedin.com/in/cvkeitz

 

 
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