Discount Rate Change Unimportant For Preferred Stock Investors

You may have read about the February 18 increase in the Federal Reserve’s discount rate. As far as preferred stock investors are concerned, that move makes no difference to us. This is the interest rate that banks are charged for short-term Fed loans. The reason that the February 18 increase does not affect preferred stock investors is that banks have so much reserve cash that they are not actually using the Fed’s “discount window” to borrow money these days. So increasing the discount rate matters very little.

To the extent that banks are borrowing from the Fed, they have been using a different facility called the Term Auction Facility. That program is scheduled to end in March. To discourage banks from going to the discount window for short-term loans, the discount rate was bumped up while the federal funds rate remains unchanged at near-zero.

By discontinuing the Term Auction Facility, increasing the discount rate and leaving the federal funds rate unchanged at near-zero, the Fed has created an environment where banks will get these short-term loans from each other, rather than from the Fed so no new money is injected into the system.

This approach eases the inflationary pressure that injecting new cash would otherwise create.

In this complex maneuver, the Fed is able to reduce inflationary pressure without increasing the cost of money throughout the economy (which would be deadly for many businesses at this point).

It is the federal funds rate that will have an impact on preferred stock investors since it is this rate that directly influences the interest rates offered by corporate bonds and new preferred stock issues.

As long as the Fed holds off increasing the federal funds rate, the crisis-caused excess yield within the preferred stock market will continue to be eliminated (i.e. market prices should continue to increase; by how much? see related article from the February issue of the CDx3 Newsletter). It is the federal funds rate that preferred stock investors should pay attention to much more so than the discount rate.

Many Happy Returns.

Two Metrics Now Key To Preferred Stock Investors

Due to low interest rates, businesses issued a record volume of new bonds and very few preferred stocks during 2009. An increase in interest rates swings the pendulum the other way as businesses start to favor issuing new equity (preferreds) rather than taking on more debt (bonds).

For preferred stock investors, increasing interest rates is therefore likely to trigger an increase in new preferred stock issues that offer higher dividends, both outcomes being positive for preferred stock investors.

As I explained in this article from the January 2010 issue of the CDx3 Newsletter (scroll down to Chart 3), inflation has been increasing since last fall and is now above the Fed’s stated ceiling of 2%. Since increasing interest rates has been the traditional means for the Federal Reserve to control inflation for several decades, preferred stock investors have been watching the inflation rate very closely.

We all know that the Fed will have to increase rates, and the inflation numbers have turned up the pressure substantially.

Now a second metric has become just as important for preferred stock investors to keep tabs on; namely, the rate at which businesses are applying to banks for new loans. Here’s why.

The Treasury and Federal Reserve dumped a massive amount of cash into bank reserves during the Global Credit Crisis. While these and other monetary moves stabilized our banking system, the cash still sitting in bank reserves has become an inflationary time bomb just waiting to go off. If banks start lending that cash out to customers, more pressure will be put on the Fed to start increasing interest rates.

One of the primary reasons that the bank-rescuing cash is still sitting in bank reserves is that there is still relatively little demand for new commercial loans from businesses. But no one should be thinking that banks will not push that hoard into the economy the second that businesses start asking for it.

So the rate of commercial loan applications has suddenly become more important for preferred stock investors; right up there with the inflation rate itself.

On January 10, 2010 the Fed released this chart. It shows a metric reflecting commercial loan demand. More specifically, for preferred stock investors what it shows is that the Fed is now being jabbed by a second red-hot poker to increase interest rates.

While still way down, commercial loan application volume is heading up and not just a little bit. It is unrealistic to expect banks to ignore the increasing demand.

The Fed cannot allow the trillion-plus dollars still sitting in bank reserves to be injected into the economy or your next salami sandwich is likely to run you about $50. Rightly, the Fed has started a number of programs to withdrawn the cash from reserves. But if the increasing loan application volume that this chart illustrates continues at its current pace, the Fed could begin increasing interest rates sooner rather than later in order to combat the increasing inflationary pressure that is sure to result.

For preferred stock investors, the inflation rate (published by the Bureau of Labor Statistics the middle of each month for the previous month) and, now, the commercial loan application volume have become the two key metrics to watch. When the Fed reacts by increasing the cost of money, look for an increase in new preferred stock issues offering very attractive dividend rates.

To be among the first to know about new preferred stock issues, please consider subscribing to the CDx3 Notification Service. Subscribers receive an automatic email alert when new high quality preferred stocks are about to be introduced.

Many Happy Returns.

CTZ-A Suspends Dividend

Why would people still by buying a preferred that has suspended it's dividend? On higher than average volume even. Also, if you buy a preferred while the dividend is suspended do you get those dividends when, and if, they restart?