The Fed's 'road map' to higher interest rates

The Federal Reserve made clear Wednesday that it isn’t planning to raise short-term interest rates soon.

But the central bank also got more specific about the conditions that would spur it to lift its key rate from the current zero-to-0.25% range.

Here’s how the critical paragraph in the Fed’s post-meeting statement reads:

"The Committee will maintain the target range for the federal funds rate at 0 to 0.25% and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

The bolded type is what was added to that paragraph since the Fed’s last meeting on Sept. 23.

"In citing these three conditions, the Federal Reserve has provided a road map by which market participants can gauge with greater precision the evolution of monetary policy, in particular the exit strategy for the Fed’s current stance," Tony Crescenzi, a bond market strategist at Pimco in Newport Beach, wrote in a note to clients.

"This will make the implementation of the Fed’s exit strategy more a process than event," Crescenzi said. "It will also give the Fed an ‘out’ because incoming data related to the three conditions mentioned will take on greater weight than the Fed’s own words, allowing the Fed to simply rubberstamp the conclusions drawn by market participants regarding the incoming data."

The first condition mentioned -- "resource utilization" -- could apply to both labor and factory capacity, both of which are severely underutilized at the moment. No debate there. Even if the economy keeps expanding, the Fed is saying that it wants to see labor and industrial slack taken up before it will think about tightening credit.

To measure whether inflation trends are "subdued," the Fed presumably would rely on the government’s major inflation gauges, including the consumer price index and the so-called personal consumption expenditures price index. The year-over-year gains in the "core" indexes of those gauges were 1.5% and 1.3%, respectively, in September, which in both cases would qualify as "subdued."

To measure whether inflation expectations are "stable," the Fed could look at future price increases implied by interest rates on Treasury inflation-protected bonds, and at trends in gold prices and the dollar.

Crescenzi noted that the Fed’s statement specifically referred to longer-term inflation expectations as being "stable" at the moment.

But are they?

"It is intriguing that the Fed would label inflation expectations ‘stable’ when the amount of inflation expectations embedded in 10-year inflation-protected Treasuries reached its highest point of the year -- 2.14%, indicating that 10-year inflation-protected Treasuries are priced for the consumer price index to increase at a 2.14% [annualized] rate over the next 10 years," Crescenzi said.

Gold, hitting record highs this week, also could be signaling rising inflation expectations. But gold’s new bull run also could be pointing to something more visceral -- increased distrust of all paper currencies -- rather than heightened concern about inflation.

-- Tom Petruno

Rates rise on inflation-adjusted U.S. savings bonds

The rebound in oil prices since March has had one beneficial side effect for savers: Interest rates will rise on Series I U.S. Savings Bonds, which earn returns adjusted for the inflation rate.

Series I bonds bought between Nov. 1 and May 1 will earn an annualized interest rate of 3.36% in their first six months, up from the zero earnings rate on newly issued bonds in the previous six months, the Treasury Department said today.

Series I bonds earn the combined total of their fixed annual rate, which is set for the 30-year life of the bonds, and the inflation rate as measured by the consumer price index. The inflation adjustment is recalculated every six months for new and outstanding bonds.

The new fixed rate on Series I bonds is 0.30%, an increase from the 0.10% fixed rate on bonds sold in the previous six months. So the government got a little more generous with the part of the return that it controls.

The inflation component will provide an annualized return of 3.06% on new I-bonds in their first six months after issuance, as well as on previously issued bonds as they adjust. Add the 0.30% fixed rate to 3.06% to get the total return of 3.36% on newly issued securities.

The surge in oil prices since mid-February pulled the consumer price index higher through Sept. 30. By contrast, plummeting oil prices had helped drive the CPI down in the six months through March. With the CPI negative for that period, Series I bond returns when adjusted May 1 paid no inflation adjustment -- the first time that had happened for any six-month period since I bonds were launched in 1998.

Still, I-bond investors are guaranteed that their returns can never fall below zero, even if the CPI were to decline again.

I bonds were far more attractive a decade ago, when the Treasury was offering fixed rates as high as 3.6%. Even so, if you think inflation will revive in the next few years thanks to the government’s massive effort to reflate the economy, I bonds still would offer a way to preserve your purchasing power by rising in line with the CPI.

Owners of previously issued I bonds can see their new earnings rates in a chart provided on savings-bond-advisor.com.

Also today, the Treasury said Series EE bonds issued in the next six months will earn 1.2% a year for the life of the security, up from 0.70% on EE bonds issued in the previous six months.

-- Tom Petruno

 

Demand exceeds supply as state wraps up $8.8-billion debt sale

Investors’ desperation for decent income played into California’s hands this week, as the state wrapped up its mammoth sale of $8.8 billion in short-term debt.

The offering drew total demand of $9.23 billion, as institutional investors today fought to get the relatively little that was left over after individual investors snapped up most of the securities.

Treasurer Bill Lockyer said institutions such as mutual funds bid for $2.59 billion of the notes. Those investors will get just $2.16 billion of what they sought because Lockyer said he would fill all of the $6.64 billion in prior orders from individual investors.

As expected based on the state’s guidance late Tuesday, Lockyer set the final yields on the two series of notes at the low end of the initial predicted range. The notes that will mature May 25 will pay an annualized tax-free yield of 1.25%; the notes maturing June 23 will pay 1.50%.

Those are paltry returns, but they beat what investors can find on most other short-term fixed-income securities -- which is why the turnout for the note sale was so huge, despite the state’s weak overall credit rating. The average money market mutual fund yields a mere 0.06%.

"People are really hungry for yield," said Marilyn Cohen, head of bond investment firm Envision Capital Management in L.A.

A year ago, amid the financial markets’ meltdown, California had to pay an average yield of 4% to borrow via short-term debt.

Lockyer figures that the state saved $15.5 million in interest costs on this week’s deal relative to what he might have had to pay if investor demand had been weaker.

That nearly covers the $16.2 million in commissions the state paid the brokerages that handled investor orders for the notes.

Lockyer also spent $600,000 on radio and newspaper ads to drum up interest in the offering. The ads ran in California and also in New York, Miami and Dallas.

The securities in this deal, known as revenue anticipation notes, bring the state cash it needs to fund spending until expected tax revenue arrives later in the fiscal year. The proceeds also will be used to repay a $1.5-billion loan the state got from JPMorgan Chase & Co. last month.

-- Tom Petruno

State tells investors to expect yields on debt sale at low end of range

Strong investor demand for California’s $8.8-billion debt sale this week will keep the state’s interest cost on the money at the low end of the expected range, Treasurer Bill Lockyer said Tuesday.

Brokerages had orders from individual investors for $6.64 billion of the short-term notes as of 5 p.m. Tuesday, Lockyer said.

Institutional investors, such as money market mutual funds, will put in orders on Wednesday, which is when the final yields on the notes will be set.

But with 75% of the deal already claimed by individual investors, Lockyer said he expected the state to set the final yields relatively low.

There are two series of notes in the deal: One matures May 25; the other matures June 23. Lockyer said investors were advised today to expect an annualized yield of 1.25% on the May notes and a yield of 1.50% on the June series.

On Friday, the treasurer had estimated that the state might pay as much as 1.50% on the May notes and 1.75% on the June notes.

The lower the yield, the bigger the savings for California taxpayers. Lockyer said brokerages had individual-investor orders for $697 million of the May notes and $5.94 billion for the June notes. Investors have the option of canceling their orders if they don't like the final yield the state sets.

The so-called revenue anticipation notes will bring the state cash it needs to fund spending until expected tax revenue arrives later in the fiscal year. The proceeds also will be used to repay a $1.5-billion loan the state got from JPMorgan Chase & Co. last month.

California is benefiting from investors’ hunger for yield as the Federal Reserve keeps short-term interest rates overall depressed to help the economy and banking system.

The interest on the state’s notes is exempt from state and federal income tax for California residents. Even at 1.25% the notes would pay far more than many other short-term securities. The average money market mutual fund yield currently is a mere 0.06%.

As I’ve noted previously, though, California still is paying a penalty relative to the debt costs of states in healthier fiscal shape.

Texas last month sold $5.5 billion in short-term notes at an annualized yield of just 0.48%.

-- Tom Petruno

Photo: Treasurer Bill Lockyer

U.S. money market fund guarantee, R.I.P.

After today, money market mutual fund accounts no longer will have the backing of the U.S. Treasury. Uncle Sam is betting that fund investors won’t care -- or won’t notice.

The Treasury is allowing its year-old guarantee of money fund assets to expire, in one of the first big reversals of the government’s involvement to stem the financial crisis.

The unprecedented backstop was put in place a year ago after one of the nation’s biggest money funds, the Reserve Fund, suffered a run on assets because of losses tied to Lehman Bros. IOUs that it owned.

The government’s blanket guarantee of fund accounts had the desired effect: After a record outflow of $120 billion in the week ended Sept. 23, fund assets quickly stabilized. Confident investors soon began adding more cash to the funds -- even though the Treasury’s guarantee only covered industry assets as of Sept. 18.

After hitting a record high of $3.85 trillion in January money fund assets have been gradually declining, reaching $3.45 trillion this week. But the slide more likely is the result of investors pulling cash to invest in riskier assets (i.e., stocks and bonds) than because they’re worried about the U.S. guarantee expiring.

With the Federal Reserve committed to holding short-term interest rates near zero indefinitely, the funds are earning little on the short-term corporate and government debt they buy. Their investors, in turn, are earning next to nothing, even though most funds are waiving all or most of their management fees: The average taxable money fund pays an annualized yield of just 0.06%, according to IMoneyNet Inc.

Pete Crane, editor of the Money Fund Intelligence newsletter, notes that even though the guarantee program is disappearing many of the debt securities that money funds own retain some kind of government or Federal Reserve backstop, thanks to the alphabet soup of lending programs put in place amid the credit crisis last fall.

Under one program, for example, the Fed would finance bank purchases of certain money fund assets if the funds needed to sell quickly to meet redemptions.

The bigger issue on the horizon: proposals to revamp the basic structure of money funds, to make another emergency situation less likely. The Securities and Exchange Commission is sorting through a raft of ideas aimed at boosting money fund safety. The President’s Working Group on Financial Markets will issue its own proposals by Dec. 1.

The most hotly debated question: Should the funds be forced to float their share prices rather than maintain the $1-a-share constant value that has been the industry hallmark for nearly 40 years?

A year ago it was Reserve Fund’s warning that it would "break the buck" because of heavy redemptions that triggered the run on other funds. In theory, if money fund investors knew their principal value could fluctuate slightly from day to day they couldn’t be stunned by another Reserve Fund-like episode.

Not surprisingly, however, the money fund industry is loathe to give up the accounting mechanics that allow funds to commit to a constant $1 share value, even though they can’t explicitly guarantee that they'll honor that price if you want your money back.

Stable pricing provides "enormous benefits to money market fund investors," said Paul Schott Stevens, head of the Investment Company Institute, the trade group for mutual funds. That's true. But for millions of people and companies, stable pricing also is critical for keeping money funds competitive with guaranteed bank deposits. Take away the constant share value and I'd bet many money fund investors would head straight for the bank.

-- Tom Petruno

Photo: The Treasury building in Washington. Credit: Chip Somodevilla / Getty Images

California sets short-term debt sale for Sept. 21-23

California’s planned sale of up to $10.5 billion in short-term notes is scheduled for the week of Sept. 21, Treasurer Bill Lockyer’s office said today.

The debt, known as revenue anticipation notes, or RANs, will bridge the gap between near-term state spending and tax revenue expected later in the fiscal year.

The money raised also will repay a $1.5-billion loan that JPMorgan Chase & Co. made to the state last week. That loan will allow Lockyer to begin redeeming IOUs issued by Controller John Chiang since early July, when the state first began to run short of cash.

Lockyer is counting on heavy demand for RANs from individual investors looking for a place to stash savings, given the rock-bottom yields available on alternative investments such as U.S. Treasury bills and money market funds.

It isn’t clear what annualized yield the state will have to pay on the debt to attract investors, but Wall Street estimates generally range from 1% to 3%. For California investors, that return would be exempt from state and federal income tax.

The notes will most likely mature in May or June. They must be paid off by June 30, the end of the current fiscal year.

Individual investors will be permitted to place orders for the notes on Sept. 21 and 22 via brokerages, with a minimum order of $5,000. Institutional investors, such as mutual funds, then will place orders on Sept. 23, and that’s the day the final yield on the notes will be set.

If individual investors don’t like the final yield, they can rescind their orders.

You’ll have to have a brokerage account to buy the notes. The investment banks handling the sale will be led by JPMorgan, Citigroup Global Markets and De La Rosa & Co.

-- Tom Petruno

Your bank failed? Your CD yields may be hacked

Depositors of the two Inland Empire banks that failed on Friday -- Vineyard Bank and Temecula Valley Bank -- need to be prepared for possible interest-rate deflation.

Under Federal Deposit Insurance Corp. rules, when a failed bank is sold the acquiring bank isn't obligated to stick with the failed institution's deposit rates, such as on savings certificates.

The buyer has the right to arbitrarily reduce deposit rates. The only stipulation is that depositors must be given the right to withdraw their money in full -- with interest earned to that point and without an early-withdrawal penalty -- if they don’t want to accept new, lower rates.

Vineyard, with $1.6 billion in deposits, was bought by California Bank & Trust of San Diego, a unit of Zions Bancorp. After CB&T took over the failed Alliance Bank of Culver City in February it notified Alliance’s customers that it was cutting deposit yields across the board.

A CB&T spokeswoman said Monday that the bank hadn’t made a decision yet about Vineyard’s deposit rates.

But Vineyard had been offering above-average yields on certificates of deposit, trying to pull in cash to stay afloat. Early this month it was quoting 1.92% on a one-year CD, compared with a national average of about 1.4%, according rate-tracker Informa Research Services.

Temecula Valley Bank, with $1.3 billion in deposits, was bought by First Citizens Bank and Trust of Raleigh, N.C. First Citizens spokeswoman Barbara Thompson said the bank was "looking at the rates" that Temecula Valley was paying but hadn’t made a decision about changing them.

-- Tom Petruno

U.S. savings rate: Not as good as it looks, but getting better

The government's measure of Americans' savings rate soared in May to the highest level in 15 years, but the number isn't quite what it seems.

The Commerce Department measures total personal income, then deducts personal spending to arrive at what was saved. That isn’t a very scientific way to determine whether or how much people actually are saving, because a single month’s data can be skewed by unusual items.

That’s what happened in May: One-time federal stimulus payments of $250 each to retirees and others receiving government aid -- so-called transfer income -- drove total personal income up 1.4% from April, while spending rose a modest 0.3%.

That boosted what the government calculates was left in people's pockets. Savings as a percentage of total disposable income jumped to 6.9% from 5.6% in April.

"With spending up only 0.3% . . . the extra income pushed the personal saving rate to 6.9%. However, this will come off [in June] as transfer income falls back to more normal levels and as some of the money works its way into the spending stream," economists at Goldman Sachs noted in a report today. They believe the underlying savings rate remains near the 5.6% level of April.

Still, that’s a vast improvement from what had been an official U.S. savings rate near zero for much of the time from 2005 through early 2008. The rate was just 0.4% in 2007.

Given the economy’s crash, many people clearly have gotten religion about saving money, if they're at all able to do so. And banks are one of the biggest beneficiaries of that shift, as they rake in cheap deposits from people who don’t want to take risks with the money they’re salting away.

Just since mid-September, when the economy fell off a cliff, total savings deposits at U.S. banks have surged by $500 billion, or 12.5%, to $4.48 trillion, according to Federal Reserve data.

That isn’t all individuals’ money; savings deposits, which include bank money market accounts, include the cash of businesses and others that use those accounts.

In any case, bankers love it: Most, of course, pay much less on savings accounts than they do on certificates of deposit. The average annualized yield on bank money market accounts with a minimum $10,000 deposit now is 0.57%, according to rate tracker Informa Research Services.

By contrast, banks are paying an average of 1.41% on one-year CDs.

-- Tom Petruno

Photo: A consumer using a coin-counting machine in Fairless Hills, Pa. Credit: Mel Evans / Associated Press

 

SEC proposes rule changes to boost money fund safety

Money market mutual funds, already paying near-zero yields, could see those payouts fall further under proposed new rules to boost the safety of the portfolios.

The Securities and Exchange Commission today proposed tightening restrictions on money funds’ investments, hoping to avoid a repeat of the sudden demise of the $60-billion Reserve Primary fund last September.

Money funds, which hold a total of $3.6-trillion in investors’ savings, would have to hold more of their assets in only the most liquid securities, so that they have ready cash to pay off investors who want out.

The most liquid assets also typically pay the least, so owning more such securities probably would put more downward pressure on fund yields. The average taxable money fund’s annualized yield now is a mere 0.13%, according to iMoneyNet Inc.

Money funds already are designed to allow investors to get in or out at will, at a constant $1-a-share asset value. But when investors deluged the Reserve Primary fund with redemption notices in September it was unable to meet all of those requests.

That triggered a run on other money funds, forcing the U.S. Treasury to step in and guarantee fund assets to stem investor panic.

SEC commissioners today proposed that funds serving individual investors would have to hold at least 5% of their assets in cash, Treasury securities or other investments that could be sold in one day. At least 15% of assets would have to be in securities that could be sold within a week.

Those percentages would be doubled for funds that serve institutional investors.

The SEC also proposed that the maximum average maturity of fund holdings be cut to 60 days from the current 90 days, which also would likely depress portfolio yields further. . . .

Money funds' stable $1-a-share pricing facing U.S. review

Money market mutual funds could eventually be forced to float their share prices rather than maintain the constant $1-a-share value that has made the industry a popular haven for investors’ cash.

That idea is mentioned in the Obama administration’s wide-ranging plan to revamp financial-industry oversight.

Regulators, the administration says, should consider whether it would be better for the financial system overall if investors were weaned from believing that money funds can’t lose principal value.

When a major money fund suffered investment losses that caused it to slightly drop its share price last September, the news triggered a run across the $3.6-trillion industry. That forced the Treasury to step in and issue a blanket guarantee of money fund assets, to calm investors.

"The vulnerability of money market funds to ‘breaking the buck’ and the susceptibility of the entire . . . industry to a run in such circumstances remains a significant source of systemic risk," the administration says in its blueprint for regulatory reform.

Because money funds own mostly short-term, high-quality corporate and government IOUs, they haven’t been required to reflect daily fluctuations in the value of those IOUs in their share prices, unless the securities permanently lose value (say, in the case of a bankruptcy).

That has allowed the 38-year-old industry to maintain $1-a-share pricing, which to investors has made the funds appear as safe as federally insured bank accounts.

The industry fears that allowing money fund share prices to float, even if the daily changes were tiny, would destroy investors’ faith in the funds.

Given the record low yields on money funds -- an average of just 0.13% currently, according to iMoneyNet Inc. -- even a slight share decline could wipe out interest earnings.

The administration said it was open to other ideas to reduce the risk the industry poses to the financial system, including requiring the funds to buy emergency insurance from private sources to damp the risk of runs.

The Securities and Exchange Commission will take up the question of money fund reforms at a meeting Wednesday, and may ask for public comment on the $1-a-share pricing issue and other possible changes in money fund regulation, Bloomberg News reported.

-- Tom Petruno