Why the Fed Might Stifle Bank Yields

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It’s complicated, but the Federal Reserve’s decision to keep interest rates low and buy long term Treasuries, using profits from its mortgage buying spree, could hurt bank rate yields in the end.

The move by the Federal Reserve Open Market Committee, announced on Aug. 10, is the Fed’s latest response to lagging economic growth and high unemployment. The economy is still a big question mark, as the Fed attested its Aug. 10 meeting, “(While) the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

With the need for a second source of stimulus high and the threat of inflation “subdued for some time,” the Fed adopted twin measures to accelerate sluggish economic growth.

The Federal Reserve opted to keep its key federal funds interest rate right where it is, right now — at 0% to .25% — and will continue to do so. Says the Fed: “The Committee will maintain the target range for the federal funds rate at 0% to .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 Fed is also embarking on a stimulus campaign to reinvest principal payments from agency debt and agency mortgage-backed securities, pouring them into long-term Treasury securities. The Fed’s adopting a long-term approach, promising to “roll over the Federal Reserve's holdings of Treasury securities as they mature.”

(For a detailed analysis of the Fed’s new Treasury reinvestment program, visit the Fed's website).

How will the move affect bank deposit investors? Not favorably. The decision to keep interest rates low – even over the long term – will continue to put a damper on bank interest rate yields. With inflation out of the picture, the Fed feels no pressure to hike rates and bring the rest of the economy along for the ride. Since bank rates generally track the Federal Reserve’s rate, we probably won’t see any significant upward movement in rates for quite a while.

Then there’s the Fed’s Treasury reinvestment program. While 30-year Treasury yields are outpacing the 30-year coupon rate on mortgage back securities, the move looks like a boon for investors angling for fatter long-term Treasury yields (the 30-Year Treasury Bond is hovering around 3.75% — a 16-month low).

But there is a caveat. The bond market will likely take a look at the bigger picture, which the Fed even summed up itself: “the pace of economic recovery is likely to be more modest in the near term than anticipated.”

The economy isn’t performing like the Fed thought it would, hence the downward revision in economic growth expectations.

While some strong voices inside the Federal Reserve calling for an end to the low-rate strategy — Open Markets Committee member Thomas Hoenig voted against the Fed policies just last week — the mandate going forward continues to be low interest rates and price stabilization in the Treasury market.

Both translate into a near-term future, at least for lower bank rate yields.

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