Meet the Street: The Fed's Comments Matter as Much as a Rate Cut

Kent Weber, Portfolio Manager, Advantus Mortgage Securities

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Ahead of Tuesday's Federal Open Market Committee meeting, many consumers are wondering what another cut in the fed funds rate could mean for them. Has the window of opportunity for mortgage refinancing closed? And for fixed-income investors, how will the yields of Treasury notes compare, going forward, to the yields of other sorts of instruments, like corporate bonds and mortgage-backed securities?

Daily Interview spoke with Kent Weber, portfolio manager at (ADMSX Quote)Advantus Mortgage Securities fund, to explore these issues.

TSC: What do you think the fed funds rate will do tomorrow?

Weber: I think there is a better than 50/50 probability that the fed funds rate will be cut by 0.25%. I think the Fed will pull the trigger and drop the rate to 1.75%. Then the debate will be: Are they done or will they cut rates further?

The commentary that comes with the cut will be as important as the cut itself. The cuts that have come fast and frequently over the last 12 months have been accompanied by a standard policy statement that says the risk is to the downside and further weakening in the economy. I think the bond market has a different opinion, given the substantial backup that we've seen in the market.

It really looks as if the market is decoupling. There is a disconnect between the Fed's actions and their effects on the short-term part of the Treasury curve . Those rates are decoupling. The rates on the front side probably will stay quite low.

TSC: What do you mean by "decoupling"?

Weber: Since Sept. 11, we've basically taken out a flight-to-quality trade -- a terrorist trade -- and the bond market is seeing higher interest rates today than it did before the hideous terrorist attacks.

But at the same time, the Treasuries, fed funds' one-year class of interest rates, continue to hold their own, if not drop. For example, the 10-year Treasury bond is actually 25 basis points higher today than it was at the beginning of the year. But the six-month Treasury bill is 400 basis points less than it was at the beginning of the year.

So the Fed is very effective at stimulating short-term rates, and that helps people who use adjustable-rate debt-financing tools. It also keeps the banking system healthy because the cost of capital is low and people can reinvest at substantially higher rates, and they make a net interest margin. But the health of the banking system was never really a concern.

For you and me and other consumers, as well as for the U.S. corporate bond players, the cost of capital is fairly fixed. Costs have not gone down, and these folks have not benefited from the lower interest-rate environment. I think that the bond market has incurred a lot of damage. It's taken an attack on the level of interest rates. With the stock market rallying up off its lows, it appears that the market is signaling that we are likely to see some kind of economic growth in the 1%-2% range by the middle of next year.

We also have to recognize that Alan Greenspan is very good at giving the bond market what it wants. Historically, the bond market has been ahead of the Federal Reserve relative to changes in the direction of interest rates. That said, I think the level of interest rates looks very attractive. If we don't see a strong recovery next year, the bond market looks appealing from a rate standpoint. It's likely that the recovery will not be as strong as the market is anticipating, and, if that is the case (take note of last Friday's unemployment figures, which are really just a lagging indicator), the Federal Reserve will go ahead and lower rates.

The short part of the Treasury curve is destined to be in the 1.75% to 2% range for an extended period of time. When you look at other fixed-income assets, like mortgage-backed securities or corporate bonds, they look extremely attractive. The net yield to consumers in those environments right now is probably approaching 6%, maybe even higher. Those are pretty attractive yields when you're sitting in a money market instrument yielding 2% with a very low inflation rate.

TSC: What about mortgage rates? Up? Down? Why? Is this a good time to refinance?

Weber: Mortgage rates have been moving in tandem with the Treasury curve. They're moving up, but not to the degree that Treasury rates are moving up. The low-end rate appears to be set; the window of refinancing opportunity for many consumers appears to have closed.

But anytime is an ideal time to refinance, depending on your situation. What is the coupon in your mortgage? What are your family goals and objectives? How long are you going to stay in your home? Do you cash out for remodeling? In reality, the mortgage has become a more versatile tool in a consumer's portfolio; how they use it and why they use it is not purely interest rate-driven. We see many people who may refinance and take equity out, even if their interest rate is a little higher, because they're consolidating debt or paying for college education or remodeling. For them, that opportunity cost is worth the extra half a percent. That mindset was rare in the past.

Rates are definitely up. We saw them dip to 6.25%, 6.375%. Now, the lowest rate to be found is 7%, with Treasuries up about 1%. Mortgage rates did not fall as much or as fast when the Treasury market was rallying, so they lagged -- and they will lag on the way up. That's why, from a total return standpoint, corporate bonds and mortgages are destined to have really good relative performance to Treasuries; they aren't sustaining the type of damage that Treasury bonds are incurring from a price-loss standpoint as the rates rise.

The Fed can only influence certain parts of the mortgage market. Primarily, it is tied to the five- and 10-year part of the Treasury curve, and that's the part of the fixed-income market that has sustained a lot of damage. It is the cause of these higher rate environments.