Coaxing investors to take more risk
With its latest steep interest rate cut, the nation’s central bank is trying again to prod skittish investors and lenders out of their protective crouch.
As the housing market has crumbled and stock prices have slumped, many individuals and institutions have been hoarding trillions of dollars in safe, short-term accounts such as money market mutual funds and bank savings certificates.
But the Federal Reserve just made those accounts far less attractive. By cutting its benchmark short-term rate to 2.25% from 3%, the Fed ensured that many cautious savers soon will be earning less than 2% -- the lowest since 2005.
“Two percent is not going to make anyone very happy,” said Brian Gendreau, a market strategist at ING Investment Management in New York.
The Fed’s move, though, is in part a strategic step to try to support battered bond and stock markets and give Wall Street a boost. By taking a machete to rates on short-term accounts, policymakers are trying to coax some cash into stocks and longer-term bonds.
If the Fed can boost confidence in financial markets, that might spill into the economy as well.
On Tuesday, it looked as if the Fed’s effort was having the desired effect, as money poured into stocks. The Dow Jones industrial average scored its biggest one-day gain since 2002 -- although it’s still down 12.5% from its peak in October.
Sustaining that turnaround, however, may not be easy, given the level of fear that has gripped the financial system since the housing market bubble burst last year, saddling banks and brokerages with enormous losses on mortgage-backed securities.
Robert Profaca, a 69-year-old retired mail carrier from Long Beach, thinks this is a bad time to be buying stocks. He fears that the housing mess has shaken the economy to its core.
“I am deathly afraid that we are heading for a very bad time, and I hope and pray I’m wrong,” he said.
In Lake Forest, insurance broker Gary Weigel said he got out of stocks completely about a month ago, after he grew weary of watching his 401(k) retirement savings balance sink.
He said he preferred to keep his cash now in “anything of low risk,” including money market funds. “At least with what I am doing, I can say that I will have my principal” back no matter what else happens, the 53-year-old Weigel said.
That wary mentality is shared by many bankers -- a big reason the housing-centered credit crunch has worsened in recent months. They are reluctant to lend to anyone with the remotest risk of defaulting.
Even among some veteran institutional investors and lenders, “the view is, ‘I don’t care what the return is, I just want to be sure I’m getting my money back,’ ” said Doug Peta, market strategist at J&W; Seligman Co. in New York.
What falling short-term interest rates do, however, is make it more profitable for banks to lend money, because their cost of funds is sliding.
The Fed is saying to banks, “If you can’t make money at [these rates], you don’t deserve to be in business,” said Marc Pado, market strategist at brokerage Cantor Fitzgerald.
In simplified terms, if a bank pays just 2% for deposits and can reap a 6% rate on a mortgage, it’s earning a profit of 4 percentage points -- a hefty return. Unless, of course, that mortgage comes back to haunt the bank in a foreclosure.
Fear of mounting loan losses is likely to keep many lenders sidelined despite the Fed’s efforts, said James Sarni, a managing principal at investment firm Payden & Rygel in Los Angeles.
He believes the financial system is so shell-shocked that many lenders, and investors, won’t step back in until they see the government begin to buy up a large chunk of troubled mortgages to hold, and work out, over the long term.
“I’m afraid that’s the only way out,” said Sarni, whose firm manages $54 billion.
Other Wall Street pros, however, note that rock-bottom short-term rates have helped markets and the financial system out of trouble before.
Following the recession of 2001 the Fed cut its key rate to 1% in mid-2003 and held it there for one year. That underpinned the stock market’s recovery in 2003 after its plunge from 2000 to 2002.
Investors always are torn between fear and greed, said James Paulsen, investment strategist at Wells Capital Management in Minneapolis.
Fear rules in depressed markets as investors seek to limit losses. But once markets turn up, greed takes over in the desire to avoid missing out on rising securities prices.
“There will come a day when greed overtakes fear again,” Paulsen said.
That day may get here sooner, he said, if investors sour on the paltry rates they’re earning on safe accounts.
Individual and institutional investors have stuffed record sums into money market mutual funds this year. Assets of the funds, which invest in short-term IOUs of companies, government agencies and banks, have ballooned by $316 billion since Jan. 1, to $3.4 trillion, according to Money Fund Report in Westborough, Mass.
The average annualized yield on the funds now is 2.73%. That’s down from 4% on Jan. 1 -- and it’s about to go lower.
As the Fed’s latest cut works through the financial system, the average money fund yield is likely to drop below 2% within six weeks, said Connie Bugbee, editor of Money Fund Report.
Likewise, yields on bank savings certificates will fall further. The average yield on six-month certificates is 2.64%, down from 3.86% six months ago, according to Informa Research Services in Calabasas.
Subtract inflation and taxes from current yields and the “real” returns already are negative and will get more so as rates fall further, analysts note.
Of course, many savers in short-term accounts aren’t cut out for risk-taking and probably shouldn’t move their money regardless of the yield.
“The people who are really getting stung by this are those living off fixed incomes,” mainly retirees, Bugbee said.
But the Fed has shown before, and is showing now, that it will sacrifice the earnings of such savers to persuade gutsier investors to again take risks.
That could just sow the seeds of the next investment bubble. But at the moment, that concern is taking a back seat to the Fed’s effort to reinstill confidence in the weakened financial system.