Right now, my loan production team at Newmark has several loan applications under negotiation where the long-term interest rates are not yet locked. These borrowers are watching rates closely and were hoping for an announcement by the Fed at their September 13th meeting of more Quantitative Easing, the long anticipated QE3. They got their wish and more – a commitment by the Fed to keep rock-bottom rates through 2015 as well as to buy $40 billion in FNMA and Freddie Mac bonds each month with no end in sight. The stock market rallied. And, interest rates reacted: BY GOING UP!
I was caught by surprise on this one...
- I was predicting that the Fed would keep QE3 in their quiver as that last arrow to use if the financial markets melt down due to sovereign defaults and resulting bank-runs in Europe.
- If the Fed wants to help the economy to push the election in Obama’s favor, I felt it was too late. It takes a long time for the economy to feel the effects of lower interest rates. Plus rates are already so low, the effects of more easing would be minor.
- I expected QE3, with its commitment to buy bonds, would raise the price of bonds and lower interest rates.
What I did not recognize was:
- The Fed knew QE3 would create a short-term run up in the stock market. And, when stock markets boom, incumbents get reelected.
- The anticipation of rates staying low for three more years, makes investors change their asset allocation plans. These tidal changes is vast pools of investor-funds effects interest rates far more than $40 billion in monthly bond purchases.
Most pension funds are set up with long-term return projections of 7.0% to 8.0%. (Public employee pension plans are underfunded today based on these optimistic projections. If they used realistic return projections, of say 4%, these funds would be so far underwater that all tax receipts would need to go into these retirement accounts with no funds left over to run City and State governments.) Here in California, CalPers and CalSters use 7.5% as their average projected annual return. This compares to CalPers’ returns in 2011 of approximately 1.0%. Since only the riskiest of junk bonds return 7.5%, if pension investors want to pretend they can hit their 7.5% average annual return target with low bond rates projected for three more years, they need to shift more money from bonds into stocks. These are vast sums of money.
Will this stock market rally last long-term?
Without fundamental changes to our weakened economy, the answer is NO.
"The problem is that the Fed doesn't have anything nutritious on its shelf right now," said Anthony Sanders, a finance professor at George Mason University and a senior scholar at the Mercatus Center. "They're just doing sugar highs. The stock market is getting a sugar rush. But the economy can't thrive on sugar rushes. It thrives on nutritious foods, which the Fed can't give out."
Professor Sanders uses the sugar analogy. This reminded me of the cartoon I published in June this year, just updated with a new steroid formula!
