Dan Greenhaus is at the Equity Strategy Group at Miller Tabak + Co. where he covers markets and portfolio theory. He has contributed several chapters to Investing From the Top Down: A Macro Approach to Capital Markets (by Anthony Crescenzi).

This is his most recent commentary:


The FOMC meets today for the final time in 2010. As we discussed in our 2011 FOMC preview, Assessing the Change in the 2011 FOMC, next year brings a slightly more hawkish Fed although one not quite able to meaningfully later the path of monetary policy. In 2010, the slightly less hawkish Fed will finish out the year on a boring note as we expect very little in the way of significant changes to the FOMC statement.

Since the last FOMC statement, incoming economic data have been generally quite good. The November 3 FOMC statement preceded the October employment report as well as other releases, including the ISM index, which have generally shown a continuing expansion. Along with the recently-announced-but-not-yet-approved-tax-compromise, we have become more optimistic about 2011 than we had been. The Fed will probably have to acknowledge this improvement in its first paragraph, perhaps in the first sentence. However, all eyes will be on the second paragraph and the following sentence:

Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate

This is the sentence that has proven to be something of a lightening rod and we guess is the origin of the recent push to eliminate the Fed’s dual mandate. Changes to this line, despite the economic improvement, are quite unlikely. It is simply too soon for the Fed to judge its program a success or failure and they may include a section on the effectiveness of the asset purchase program saying, in December’s case, that it is too soon to judge the program. Going forward, this paragraph could be used to signal the Fed’s thoughts on the program to the market. If the Fed were to abandon the program earlier than its scheduled completion date, they could do so in this paragraph.

Other than that, we do not anticipate very many, if any, changes to the statement. The Fed will certainly leave itself the flexibility to “adjust the program as needed” while also leaving unchanged the sentence regarding “exceptionally low levels for the federal funds rate for an extended period.” They may include a section on the effectiveness of the asset purchase program saying, in December’s case, that it is too soon to judge the program.

On a related topic, we continue to field questions both internally and externally regarding the recent run up in yields and why, as Carl Quintanilla said on CNBC this morning, the bond market is not “playing ball.” To repeat, the Fed is not out to peg the 10 year rate at, say, 2.50%. If that’s what they wanted, Ben Bernanke could come out and just say “we will purchase any and all bonds in an effort to target a 2.50% rate on the 10 year note.” He hasn’t said something like that because that’s not the goal. The goal is deflation prevention. Viewed this way, the back up in rates is a welcome development, signaling and end, for now, to deflationary concerns. The Fed knows that an improved economic landscape is going to be associated with higher yields and higher inflation expectations. In that regard, they are quite happy and would more than likely judge the steps they’ve taken, from a communications and implementation standpoint, to be a success.

^^This morning its being reported that the ECB is contemplating asking regional governments for a capital infusion to insure itself against any losses related to its efforts to shore up the sovereign debt market. We have nothing to add with regards to the story but this does give us an opportunity to once again opine on the possibility of Fed losses. As we know, the Fed’s balance sheet has ballooned up to $2.385 trillion as of the most recent week, nearly 50% of which is invested in MBS and agency debt securities. Another near 40% is in various forms of Treasury securities. This exposure has led to a modest bit of discussion as to whether, whenever short term rates begin to rise, the Fed will be able to sustain the losses it is sure to incur. However a related issue is worth mentioning, one that NY Fed President Dudley touched on this topic in an early October speech.

The concern about Fed funding arises from its decision to pay interest on excess reserves, currently 0.25%. In the Fed’s opinion, this newly granted ability was and is instrumental in building the foundation for an orderly exit from accommodative monetary policy. Simply put, as the FOMC begins to pay a higher IOER, they will of course have to lay out more money. As a self funding institution that cannot go to Congress for additional appropriations, this raises a concern about if and when the Fed may need funds to meet such outlays. One big potential complication regarding this issue is the fact that the Fed is forced to remit its earnings to the Treasury each year (they may remit as much as $80 billion in 2010 alone after sending $47.431 billion in 2009). They are, as best as we can tell and are told, not able to build up a capital cushion against potential future losses.

With the Fed earning about 4% on its various investments, there is no concern about paying out more money than it is currently earning. However, as rates rise, this spread will compress as the Fed pays a higher IOER. To be sure, there is ample time for this becomes a legitimate and pressing concern but it is one worth knowing exists.

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