Fixed Income Weekly

This week the market’s attention was focused primarily on comments from various Fed officials and the minutes from December’s FOMC meeting.

The Fed minutes were pretty uneventful. Some voting members are content with winding down the Fed’s purchasing program on schedule (March) while others are pushing a possible expansion of the program in order to protect the still fragile housing market from the exit of the mortgage market’s biggest investor.

So far the Fed’s exit strategy has been limited to emergency lending programs that have been slowly unwinding due to decreased demand, but if the March does end up being the final month of MBS purchases it will be the first active step by the Fed to begin tightening. It’s not surprising to see some disagreement within the FOMC.

Bernanke
Several Fed officials spoke this week, but Bernanke’s speech on Sunday at the Annual Meeting of the American Economic Association in Atlanta caught my eye. The argument he presented was based on his belief that a lack of regulation, not unnecessarily low interest rates, led to the housing bubble.

From Big Ben’s speech…
The most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards… The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter.

This argument isn’t anything new from the Fed. The street is used to investors like Bill Gross talking up their positions on CNBC, and that’s all the Chairman is doing here. We are entering the second year of a 0-.25% target for Fed Funds and there are still 3-months to go until the Fed is finished buying MBS, so unless he wants the bond vigilantes to run his current monetary policy out of town he better keep up this sort of talk.

Exotic mortgage products did help bring monthly payments down, which in turn brought a much stronger bid to the property market. But Option Arms and the like came about only because there was enough demand from investors (Banks, Hedge Funds, Pensions, etc.) for those products. Extremely low interest rates, if left too low for too long, incentivizes investors to ignore risk in their search for additional yield which leads to more bubbles and more instability in the future. Talk up your position if you want Chairman Bernanke, but relying heavily on regulation instead of worrying about the effect monetary policy can have on asset prices is foolish and irresponsible.

Have a good weekend.

Cliff J. Reynolds Jr., Investment Analyst