Explaining Southern California's economy

The investors' view on the Federal Reserve's interest rate decision

Ben Bernanke

Alex Wong/Getty Images

Federal Reserve Chairman Ben Bernanke. Will continued low interest rates lead to inflation? Some money managers don't think so.

The Federal Reserve's Open Market Committee announcement Wednesday wasn't a big surprise on the interest-rate front. The Fed has stated it intends to keep short-term rates low for the foreseeable future, in an effort to stimulate the economy and push investors into riskier assets, like stocks. A continued low-interest rate environment will also continue to bolster the housing market, where mortgage rates are at historic lows.

Fed Chairman Ben Bernanke and the rest of the FOMC annouced that they will keep rates low until unemployment falls to 6.5 percent. It will also continue to buy up mortgage-backed securities, at roughly the same rate it has been (so-called "Quantitive Easing," installment 3, or "QE3").

[UPDATE: I slightly misinterpreted what the Fed is doing on the bond-buying side. It's also worth noting that the Fed is now saying that it will keep interest rates low until unemployment hits a specified level. This is a policy departure from saying that rates will stay low until the economy improves. But anyway, bond-buying: the Fed is going to double what it's doing in the QE front and change "Operation Twist" into an extension of QE3. The older aspect of QE will still involve buying MBS. But the additions to QE3 will entail buying long-term U.S. Treasuries without selling short-term bonds. This is important as it means the Fed will be adding $85 billion per month to its balance sheet — under Operation Twist, it hadn't grown much, which was viewed as an way to "sterilize" against inflation. Former Dallas Fed President Bob McTeer has a good post about the FOMC decision at Forbes.]

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California city bankruptcies are raising questions about the municipal bond market

Muni-Defaults

Federal Reserve Bank of New York

Last month, I wrote about Moody's, one of the big ratings agencies, and its view that the municipal bond market was getting a bit riskier than everyone has conventionally thought, in the aftermath of the bankruptcies of Stockton and San Bernardino and other U.S. cities. 

At the time, I noted that between 1970 and 2011, Moody's could find only one city — Cicero, New York — "electing to default on debt not out of ability to pay but willingness to pay."

What that implies is that the now $3.7-trillion muni bond market has been a safe investment for decades. As long as you're investing in rated bonds. (And even if you haven't, but more on that in a sec.)

Now the Federal Reserve Bank of New York has offered its own take, at its Liberty Street Economics blog. It differs from Moody's in terms of the looking at the entire muni market, not just the part that's rated by Moody's and others. The conclusion is represented in the graphic above. Moody's found 71 defaults between 1970 and 2011 — and that's total defaults in its rating universe, so presumably 70 we due to inability to pay while only Cicero strategically defaulted due to an unwillingness to pay.

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Bond markets haven't signaled a California municipal meltdown

donielle/Flickr (cc by-nc-nd)

Compton may become the next California city to declare bankruptcy. But the municipal bind market isn't panicking.

One of the things that's struck me about the two most recent bankruptcies — or almost-bankruptcies — in California, San Bernardino and now Compton, is that the bond markets aren't predicting a crisis. Reuters MuniLand columnist Cate Long has been following all the recent action in California's troubled cities and correlating it with what's going on in the $3.7-trillion municipal bond markets and she sees...no cascade of impending Chapter 9s:

American cities and states are enduring a lot of fiscal stress, and in some cases their municipal bonds are showing stress too. But overall the muni bond market feels comfortable with the debt of U.S. states and cities. The data does not suggest a broad meltdown.

In that context, she cites Guy Davidson of AllianceBernstein, a firm that according to Long has $3.3 billion in California muni exposure (and $31 billion under management in total) and that therefore might want to argue against a panic in MuniLand. This is from Davidson's blog post:

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