Stocks and bonds take away different messsage from the Fed

11/04/2009 6:35 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Bonds and shares of financial companies didn’t like what they heard from the Federal Reserve Wednesday November 4 at 2:15.

Investors and traders in general, on the other hand, were relieved that the Federal Reserve signaled that interest rate policy wasn’t about to change and that any interest rate increase was still a long way off. That’s good news from that perspective because it means that borrowing a weak dollar at a very low interest rate in order to invest in higher returns in overseas markets or in U.S. commodity related stocks is going to stay very lucrative for a while longer yet.

And, of course, in general, lower interest rates are good for stocks since they reduce the attractiveness of investments in asset classes such as bonds or money market funds.

That’s why after selling off in the 10 minutes immediately after the Fed’s announcement, the Dow Jones Industrial Average rallied by 80 points in the next half hour.

Bonds, on the other hand, got slammed and stayed slammed. And as selling spread from bonds to financial shares that ate into the gains in the wider stock market. The Dow Jones Industrials finished the day up just 30 points.

What didn't the bond market like?

What bond traders heard the Fed say was it thought household spending was ticking up—a sign of a return to economic growth—but that, despite such signs of growth, it wasn’t concerned about inflation.

Inflation is the deadly enemy of bond investors since it makes both the income received from the bond worth less over time and eats away at the value of the capital locked up in the bond.

So bond yields moved up—and bond prices moved down--after the announcement. The yield on the 10-year Treasury note climbed to 3.556% from 3.501%. That doesn’t sound like much but that move results in a loss of $145 on a $10,000 note.

The yield on a 30-year bond climbed to 4.426% from 4.364 and the on a 2-year note to 0.944% from 0.936%.

But the damage inflicted by the Federal Reserve’s statement extended from the bond market into financial stocks. As part of its announcement, the U.S. central bank said it would cut the size of its program to buy up agency debt to about $175 billion. That’s $25 billion less than previously announced. In buying up the debt of agencies such as mortgage lenders and guarantors Fannie Mae (FNM) and Freddie Mac (FRE), the Fed supported the price of that debt. That’s important to big chunks of the financial sector since bank portfolios, especially big bank portfolios, are still stuffed with this paper.

The Fed also re-affirmed its stated intention of wrapping up its program of buying mortgage-backed securities issued by these mortgage agencies. That program was designed to give Fannie Mae and Freddie Mac the ability to sell packages of mortgages they bought from the banks that originated them when the pool of private buyers of such mortgage-backed securities had pretty much dried up. The program kept mortgage rates low and just as importantly supported the price of the mortgage-backed securities in bank portfolios. The program, which will have purchased a total of $1.25 trillion of agency mortgage-backed securities during its life, will slow and then end in the first quarter of 2010, the Fed announced on November 4.

The reaction was almost immediate. By 3:00 p.m. the financial sector had started a plunge that would take the Financial Select SPDR (XLF) down from $14.339 to $14.01, a drop of 2.7% by the end of trading on November 4.

On CNBC at about the same time banking analyst Meredith Whitney, founder of Meredith Whitney Advisory Group, said that the Fed’s exit from the mortgage-backed securities market posed a danger to profits at four big banks: JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC), and Citigroup (C).

The stocks of the four banks were down 1.2%, 0.7%, 3.1%, and 1.7%.

And the drop in that sector helped take the some of the starch out of the earlier rally in the wider stock market.

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