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Federal Reserve maintains low rates to nurse economy back to health
March 18, 2010

The FOMC maintained the target range for the federal funds rate at 0 to 0.25%, while reiterating the end of its mortgage debt purchase programme in March 2010.


Author : iFAST Research Team



Untitled Document
Chart 1: "Stabilising" job market
Chart 2: Consumer spending recovering
Chart 3: "Flat" housing market
Chart 4: Mortgage rates kept low to entice buyers
Chart 5: Benign inflation

Key Points

  • FOMC maintained the target range for the federal funds rate at 0 to 0.25%
  • Economic activity strengthening, labour market stabilising, but housing seen as “flat”
  • Support via the purchase of US$1.25 trillion of agency mortgage-backed securities to cease by March
  • Inflation seen as “subdued”, expectations are “stable”
  • Expect the US housing market to weigh rate hike decisions
  • Reiterate that investors should focus on earnings and valuations, rather than interest rate policy

The highly-anticipated Federal Open Market Committee (FOMC) statement saw a continuation of low interest rate policy, but more importantly, the FOMC guided for a stance on “exceptionally low” interest rates for “an extended period”. While the latest FOMC statement was largely unchanged from January’s, there was a more positive assessment of the job market, with the labour market described as “stabilising”, compared to the “abating deterioration” mentioned in the previous statement (see Chart 1).

Housing remains troubled

Other than employment conditions, other economic segments cited in the statement were largely unchanged from January’s outlook. Despite the continued high unemployment, monthly retail sales figures continue to suggest a more positive US consumer (see Chart 2). On the other hand, home prices (see chart 3) have remained flat after housing incentives helped to stem further declines. Existing home sales however, have shown substantial weakness in recent months. A strong recovery in existing sales in the middle of 2009 resulted from homebuyers rushing purchases to benefit from a first-time homebuyer credit. However, as the novelty of the incentive wore off (the programme was extended to end April 2010), home sales tapered off, raising concerns over the weak fundamentals of the US housing market.

Purchase programme ends, but low interest rate environment to sustain mortgage rates

The Federal Reserve’s mortgage-backed security purchase programme has helped to keep mortgage rates at the lowest levels on record (see Chart 4), but the FOMC has already guided that it will cease purchases by March 2010. While this raises concerns over the sustainability of current low mortgage rates, it is more likely that the Fed has already ceased its purchase programme, and that private sector demand is sufficiently strong without the Fed’s intervention. Hence, a substantial spike in mortgage rates at the end of March is not expected to occur. Instead of directly assisting the housing sector through mortgage purchases, we see the Fed shifting this responsibility to the private sector, but providing assistance indirectly by keeping short-term rates low, driving private investors into higher yield securities like mortgages. We believe that the continued weakness in the housing sector is likely a key factor in the FOMC’s stance on keeping rates low for the foreseeable future.

Inflation seen as “subdued”, expectations are “stable”

The Federal Reserve’s preferred measure of inflation is the personal consumption expenditures (PCE) core price index, which measures the average increases in prices of all domestic consumption, excluding food and energy (see Chart 5). The measure averaged 1.5% year-on-year in 2009, and January’s 1.4% year-on-year increase is well within the previously cited 1 to 2% target range. Coupled with low capacity utilisation rates (which are recovering, but still remain far away from historical levels) and continued high unemployment, there are few indications of an inflationary threat on the horizon and gives the FOMC much leeway in keeping interest rates low.

Low interest rate environment positive for stocks, but focus on earnings and valuations

The latest FOMC statement suggests a prolonged period of low interest rates, which should boost investor sentiment in the near term. We expect continued weakness in the housing market to weigh on any future rate hike decisions, especially with the mortgage purchase programme slated to end in March. Stocks are thus likely to react positively to the Fed’s guidance for an “extended period” of low interest rates, and the continued cheap short-term funding will benefit the banking sector.

At this juncture, investors may be tempted to dwell on predicting future rate hikes, and use that as a basis for exiting their investments in the equity market. While we concede that any future hikes may be a short-term negative for the equity market, it is also possible that economic conditions may have improved drastically by then, and a hike in rates only serves to confirm the strength in the economic recovery. Instead of relying on our crystal balls to guess when the Fed will hike rates (which may or may not result in a negative reaction from the stock market – see “Exit Strategy is Underway. Good or Bad for the Global Equities?” which demonstrates that stock markets have historically moved in sync with the interest rate cycle), we reiterate our focus on earnings and valuations to form our investment basis.

As at 16 March 2010, the US stock market (represented by the S&P 500) traded at an estimated PE ratio of 10.9X based on estimated 2012 earnings, representing relatively attractive valuations. We continue to think that the US market is attractively valued, especially in the current economic recovery where earnings estimates may still be too conservative.

 

 

 

 

 

 

Table 1:US Market Valuations

 

2010E 2011E 2012E

PE ratio

14.9X

12.4X

10.9X

Earnings Growth

26.1%

20.3%

13.5%

Source: Bloomberg consensus estimates, data as at 16 March 2010

 


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 US Economic Growth may return in 3Q 2009
US: Better-than-expected 2Q 09 contraction, 3Q 09 to show positive growth


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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