Continental Capital Advisors, LLC July 23, 2010

Worrying Signs From The Federal Reserve Minutes

Last week, the Federal Reserve released the minutes of its Open Market Committee meeting that
concluded on June 23.1 Meeting participants were hopeful that the economic rebound would
continue, yet a number of statements from the minutes highlight the slowdown in the US economy.
Additionally, the Fed minutes note an increase in “fails to deliver” securities, which could signal that
the limit of quantitative easing already has been reached because of a lack of liquid securities.

The following excerpts from the minutes of the Federal Reserve’s Open Market Committee meeting
demonstrate that Federal Reserve members are aware of a slowdown in the economy:

Economic data releases were mixed, on balance, over the intermeeting period, but market
participants were especially attentive to incoming information on the labor market--most
notably, the private payroll figures in the employment report for May, which were
considerably weaker than investors expected. Those data, combined with heightened
concerns about the global economic outlook stemming in part from Europe's sovereign debt
problems, contributed to a downward revision in the expected path of policy implied by
money market futures rates.

…While the recent data on production and spending were broadly in line with the staff's
expectations, the pace of the expansion over the next year and a half was expected to be
somewhat slower than previously predicted.

…The implications of these less-favorable factors for U.S. economic activity appeared likely
to be only partly offset by lower interest rates on Treasury securities, other highly rated
securities, and mortgages, as well as by a lower price for crude oil. The staff still expected
that the pace of economic activity through 2011 would be sufficient to reduce the existing
margins of economic slack, although the anticipated decline in the unemployment rate was
somewhat slower than in the previous projection.

…In part as a result of the change in financial conditions, most participants revised down
slightly their outlook for economic growth, and about one-half of the participants judged the
balance of risks to growth as having moved to the downside.

…Indeed, data for the most recent month suggested that, with the expiration of those
provisions, home sales and starts had stepped down noticeably and could remain weak in the
near term; with lower demand and a continuing supply of foreclosed houses coming to
market, participants judged that house prices were likely to remain flat or decline somewhat
further in the near term.

…The economic outlook had softened somewhat and a number of members saw the risks to
the outlook as having shifted to the downside. Nonetheless, all saw the economic expansion

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as likely to be strong enough to continue raising resource utilization, albeit more slowly than
they had previously anticipated.

…In sum, the changes to the outlook were viewed as relatively modest and as not warranting
policy accommodation beyond that already in place. However, members noted that in
addition to continuing to develop and test instruments to exit from the period of unusually
accommodative monetary policy, the Committee would need to consider whether further
policy stimulus might become appropriate if the outlook were to worsen appreciably. Given
the slightly softer cast of recent data and the shift to less accommodative financial conditions,
members agreed that some changes to the statement's characterization of the economic and
financial situation were necessary.

…About one-half of the participants saw the risks to their growth outlook as tilted to the
downside; in contrast, in April a large majority of participants saw the risks to growth as
balanced.

In the past, statements acknowledging an economic slowdown would have prepared market
participants for the possibility of interest rate cuts. Economists would have projected interest rate
cuts into their forecasts and highlighted the benefits of lower rates for the stock market and the
economy. However, with the federal funds rate currently at 0%, interest rate cuts cannot be a part of
the arsenal used to combat an economic slowdown.

Few market commentators are discussing how the inability to cut interest rates will increase the
likelihood and the severity of a downturn. This is surprising because there have been recessions
even when the Fed could lower interest rates. In contrast, complacency exists because it is widely
accepted that the Federal Reserve has other tools to support the economy and stock market.
However, additional action by the Federal Reserve would signal its failure to revive the economy.
Therefore, we believe that the Fed is unlikely to use a “nuclear option” until there is a stock or credit
market panic.

Regardless of the timing of further Fed policy action, it is unlikely that additional quantitative easing
will lead to more than just a temporary bounce in asset markets. For one, Japan’s history
demonstrates that continuous quantitative easing does not necessarily lead to sustained economic
growth or to higher stock prices. Additionally, a further decline in long-term interest rates on
mortgages and government bonds is unlikely to be as stimulative as in the past since rates are
already so low. Finally, the following statement from the minutes of the Federal Reserve’s Open
Market Committee meeting could mean that quantitative easing has reached its practical limit:

In his presentation to the Committee, the Manager noted that ‘fails to deliver’ in the
mortgage-backed securities (MBS) market had reached very high levels in recent months.
Under these conditions, dealers had experienced difficulty in arranging delivery of a small
amount--including about $9 billion of securities with 5.5 percent coupons issued by Fannie

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Mae--of the $1.25 trillion of MBS that the Desk at the Federal Reserve Bank of New York
had purchased between January 2009 and March 2010. The Desk had postponed settlement
of some of these transactions through the use of dollar rolls. The Manager discussed
alternative methods of settling the outstanding transactions and recommended that the
Committee authorize the Desk to engage in coupon swap transactions to facilitate the
settlement of these purchases. The Manager noted that a coupon swap is a common
transaction in the market for MBS in which the two counterparties exchange securities at
market prices. By engaging in a coupon swap, the Federal Reserve would effectively sell the
scarce securities that it had not yet received and purchase instead securities that are more
readily available in the market. After discussing various approaches, meeting participants
agreed that coupon swaps were an appropriate method to achieve settlement of outstanding
transactions.

The uncommon mention of “fails to deliver” makes us wonder if the Federal Reserve is running out
of assets to buy, and therefore, also running out of policy options. While the Federal Reserve may
announce an increase in quantitative easing by trillions of Dollars, if it is unable to find liquid
securities to buy, the policy move may provide little value beyond an initial stock market squeeze.

Members of the Federal Reserve recognize that a slowdown is ahead but they lack the traditional
tools to stimulate the economy. Although increased quantitative easing is a strategy that the Federal
Reserve can pursue, it is unlikely to be effective.

1
http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20100623.pdf 

Daniel Aaronson – daaronson@continentalca.com

Lee Markowitz, CFA – lmarkowitz@continentalca.com
http://www.continentalca.com

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Comments within the text
should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their
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materially different from any future results, performance or achievements expressed or implied by such forward-looking
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