7.23.10worryingsignsfromthefederalreserveminutes

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Continental Capital Advisors, LLC July 23, 2010

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Worrying Signs From The Federal Reserve Minutes

Last week, the Federal Reserve released the minutes of its Open Market Committee meeting that

concluded on June 23.1 Meeting participants were hopeful that the economic rebound would

continue, yet a number of statements from the minutes highlight the slowdown in the US economy.Additionally, the Fed minutes note an increase in fails to deliver securities, which could signal that

the limit of quantitative easing already has been reached because of a lack of liquid securities.

The following excerpts from the minutes of the Federal Reserves Open Market Committee meeting

demonstrate that Federal Reserve members are aware of a slowdown in the economy:

Economic data releases were mixed, on balance, over the intermeeting period, but market

participants were especially attentive to incoming information on the labor market--most

notably, the private payroll figures in the employment report for May, which were

considerably weaker than investors expected. Those data, combined with heightenedconcerns about the global economic outlook stemming in part from Europe's sovereign debt

problems, contributed to a downward revision in the expected path of policy implied by

money market futures rates.

While the recent data on production and spending were broadly in line with the staff's

expectations, the pace of the expansion over the next year and a half was expected to be

somewhat slower than previously predicted.

The implications of these less-favorable factors for U.S. economic activity appeared likely

to be only partly offset by lower interest rates on Treasury securities, other highly rated

securities, and mortgages, as well as by a lower price for crude oil. The staff still expected

that the pace of economic activity through 2011 would be sufficient to reduce the existing

margins of economic slack, although the anticipated decline in the unemployment rate was

somewhat slower than in the previous projection.

In part as a result of the change in financial conditions, most participants revised down

slightly their outlook for economic growth, and about one-half of the participants judged the

balance of risks to growth as having moved to the downside.

Indeed, data for the most recent month suggested that, with the expiration of those

provisions, home sales and starts had stepped down noticeably and could remain weak in thenear term; with lower demand and a continuing supply of foreclosed houses coming to

market, participants judged that house prices were likely to remain flat or decline somewhat

further in the near term.

The economic outlook had softened somewhat and a number of members saw the risks to

the outlook as having shifted to the downside. Nonetheless, all saw the economic expansion


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as likely to be strong enough to continue raising resource utilization, albeit more slowly than

they had previously anticipated.

In sum, the changes to the outlook were viewed as relatively modest and as not warranting

policy accommodation beyond that already in place. However, members noted that inaddition to continuing to develop and test instruments to exit from the period of unusually

accommodative monetary policy, the Committee would need to consider whether further

policy stimulus might become appropriate if the outlook were to worsen appreciably. Given

the slightly softer cast of recent data and the shift to less accommodative financial conditions,

members agreed that some changes to the statement's characterization of the economic and

financial situation were necessary.

About one-half of the participants saw the risks to their growth outlook as tilted to the

downside; in contrast, in April a large majority of participants saw the risks to growth as

balanced.

In the past, statements acknowledging an economic slowdown would have prepared market

participants for the possibility of interest rate cuts. Economists would have projected interest rate

cuts into their forecasts and highlighted the benefits of lower rates for the stock market and the

economy. However, with the federal funds rate currently at 0%, interest rate cuts cannot be a part of

the arsenal used to combat an economic slowdown.

Few market commentators are discussing how the inability to cut interest rates will increase the

likelihood and the severity of a downturn. This is surprising because there have been recessions

even when the Fed could lower interest rates. In contrast, complacency exists because it is widely

accepted that the Federal Reserve has other tools to support the economy and stock market.

However, additional action by the Federal Reserve would signal its failure to revive the economy.

Therefore, we believe that the Fed is unlikely to use a nuclear option until there is a stock or credit

market panic.

Regardless of the timing of further Fed policy action, it is unlikely that additional quantitative easing

will lead to more than just a temporary bounce in asset markets. For one, Japans history

demonstrates that continuous quantitative easing does not necessarily lead to sustained economic

growth or to higher stock prices. Additionally, a further decline in long-term interest rates on

mortgages and government bonds is unlikely to be as stimulative as in the past since rates are

already so low. Finally, the following statement from the minutes of the Federal Reserves Open

Market Committee meeting could mean that quantitative easing has reached its practical limit:

In his presentation to the Committee, the Manager noted that fails to deliver in the

mortgage-backed securities (MBS) market had reached very high levels in recent months.

Under these conditions, dealers had experienced difficulty in arranging delivery of a small

amount--including about $9 billion of securities with 5.5 percent coupons issued by Fannie


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Mae--of the $1.25 trillion of MBS that the Desk at the Federal Reserve Bank of New York

had purchased between January 2009 and March 2010. The Desk had postponed settlement

of some of these transactions through the use of dollar rolls. The Manager discussed

alternative methods of settling the outstanding transactions and recommended that the

Committee authorize the Desk to engage in coupon swap transactions to facilitate the

settlement of these purchases. The Manager noted that a coupon swap is a common

transaction in the market for MBS in which the two counterparties exchange securities at

market prices. By engaging in a coupon swap, the Federal Reserve would effectively sell the

scarce securities that it had not yet received and purchase instead securities that are more

readily available in the market. After discussing various approaches, meeting participants

agreed that coupon swaps were an appropriate method to achieve settlement of outstanding

transactions.

The uncommon mention of fails to deliver makes us wonder if the Federal Reserve is running out

of assets to buy, and therefore, also running out of policy options. While the Federal Reserve may

announce an increase in quantitative easing by trillions of Dollars, if it is unable to find liquid

securities to buy, the policy move may provide little value beyond an initial stock market squeeze.

Members of the Federal Reserve recognize that a slowdown is ahead but they lack the traditional

tools to stimulate the economy. Although increased quantitative easing is a strategy that the Federal

Reserve can pursue, it is unlikely to be effective.

1http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20100623.pdf

Daniel Aaronson [email protected] Markowitz, CFA [email protected]

http://www.continentalca.com

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Comments within the text

should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their

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actual results, performance or achievements of the above mentioned companies, and / or industry results, to be

materially different from any future results, performance or achievements expressed or implied by such forward-looking

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7.23.10worryingsignsfromthefederalreserveminutes

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