But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.
Quantitative easing lowers interest rates on long-dated liabilities
The Fed started asset purchases (otherwise known as quantitative easing) as the financial crisis began to hit its peak. The Fed has traditionally influenced interest rates at the short end of the curve by lowering the federal funds target rate. This approach indirectly influences longer-term interest rates. However, the Fed decided to try to influence long-term interest rates directly by purchasing long-dated bonds and mortgage-backed securities in an attempt to ease pressure on the consumer.
Since it started asset purchases, the Fed has also instituted Operation Twist, through which it sells shorter-dated paper and purchases long-dated paper with the proceeds. We are currently in the third iteration of quantitative easing, which will continue until the Fed sees meaningful improvement in the labor market.
How to help the indebted consumer
Consumption accounts for 70% of the U.S. economy, and consumers are de-levering after the housing bust. Homeowners who did cash out refinances on their homes to fund consumption now find themselves owing more than their homes are worth. Household debt is coming down only gradually from its peak in 2007, as the following graph shows.
Clearly, as consumers, we have a long way to go to get back to the levels of debt we had before the real estate bubble started inflating. While there has been some political pressure for principal reductions on home mortgages, reductions probably won’t happen, and at any rate, the Federal Reserve has no control over home mortgage reductions.
So while debt has been decreasing gradually, debt service (which is the sum of monthly debt payments as a multiple of disposable income) is at generational lows. By lowering long-term interest rates and allowing people to refinance their mortgages (which is the biggest component of debt for people after student loans) the Fed is freeing up disposable income, which it hopes people will spend. So far, people appear to have used the extra money to reduce their indebtedness.
As consumers de-lever, consumption will increase, as it can only be deferred for so long. In fact, that is often how recessions end: consumers finally have to start spending because durable goods wear out. This demand kicks off a new virtuous circle that re-ignites the economy. Optimism over future home prices is a positive as well.
Implications for homebuilders
The Fed’s quantitative easing has helped lower mortgage rates, which helps make homes more affordable. Secondly, the large number of underwater homeowners has restricted the supply of existing homes on the market. This has increased demand for new construction. For homebuilders like Toll Brothers (TOL), Lennar (LEN), KB Homes (KBH), Meritage (MTH), and Ryland (RYL), a combination of low interest rates and restricted supply is a great state of affairs.
© 2013 Market Realist, Inc.