The Harbor Oak Group At Morgan Stanley

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1 Morgan Stanley Between a Rock and a Hard Place September 2016 The Harbor Oak Group At Morgan Stanley 6101 Carnegie Blvd Charlotte, NC College St. Ashville, NC

2 The View express herein are those of the author and do not necessarily reflects the view of Morgan Stanley or its affiliates. Printed 9/9/2016 Remember when the majority of folks had no idea who was running the Federal Reserve? Sure, most people probably remember Paul Volcker, but how about Arthur Burns or even William Martin? Nowadays it seems like people are flipping back and forth between Keeping up with the Kardashians and CNBC as they anxiously wait to hear what particular adjective Janet Yellen or Stanley Fischer use to discuss the potential for a quarter of one percent interest rate increase. Established by Alexander Hamilton in 1791, The Federal Reserve was originally called the First Bank of the United States. This was met with great opposition as many believed this would give the federal government too much power. Thomas Jefferson once stated If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered The issuing power should be taken from the banks and restored to the people, to whom it properly belongs. (FYI, he was referring to the Federal Reserve Bank). * Congress failed to renew the First Bank s Charter and it closed in Four years later, they tried again with the Second Bank of the United States, only to close in After the financial panic of 1907, Congress decided to take another crack at central banking and in 1913, Woodrow Wilson signed the Federal Reserve Act which created the Federal Reserve as we know today. I guess they were a little weary about calling it the Third Bank of the United States. * The primary role of the Federal Reserve Bank is to oversee the U.S. banking and financial systems. The Federal Open Market Committee (FOMC), a committee within the Federal Reserve, is responsible for the nation s monetary policy. Put simply, they control inflation or deflation by raising or lowering interest rates. Contrary to popular belief, the Fed doesn t just push a button and interest rates move up or down. It s slightly more complicated than that. The FOMC only controls two lending rates - the discount rate and the federal funds rate, sometimes called the overnight rate. The discount rate is the rate banks can borrow directly from the Federal Reserve and the fed funds rate is the interest rate that banks charge each other for overnight lending. Every financial institution is required to keep a certain amount of cash at the Federal Reserve and at the end of each day if a bank is short the requirement, they will simply borrow from another institution.

3 Now, to raise or lower the fed funds rate, the FOMC must first set their target rate and then attempt to control the money supply by purchasing or selling US treasuries to or from these financial institutions. So if the FOMC wants to reduce interest rates, they simply buy U.S. Treasuries which in turn gives the banks more cash to circulate and the fed funds rate moves lower. Conversely, when they want to raise rates they sell US treasuries which in turn removes cash from circulation and the fed funds rate moves up. During 2008, the fed funds rate was reduced from 4.5% to 0% in order to stabilize the struggling economy. But after rates were at zero, the FOMC had to go with plan B. They began buying record amounts of treasuries and government related bonds from financial institutions to inject more and more cash in to the economy, called quantitative easing (QE). During this period the Federal Reserve purchased close to 3 trillion dollars worth of treasuries and government related bonds and as of December 2015, the Federal Reserve s balance sheet was listed at 4.48 trillion. (The media would lead you to think that China is the largest holder of US debt but that is incorrect; it s actually the Federal Reserve.)** The good news about having this inflated balance sheet is the Fed receives interest on most of these assets. In 2015, the net income for the Federal Reserve was $99 billion and $101 billion in That s good news for the U.S. taxpayer as the Fed is required to remit this profit to the U.S. Treasury at the end of each year. ** So why is the Fed stuck between a rock and a hard place? Well we all know that when interest rates go up, bond prices fall. So when the Fed raises interest rates the price of all these bonds they have purchased will start to go down in value. This shouldn t be a problem for the first several interest rate hikes as the interest they receive will offset the losses, but eventually that $99 billion profit could turn into a deficit. I can see it now Janet Yellen trying to explain to Congress why the taxpayer is responsible for making up the Federal Reserve s losses as they unwind this monetary experiment. In a perfect world, the Fed could just keep these assets on their balance sheet until they mature. At that point, the money goes back to the U.S. Treasury and everything s good. But keep in mind; if they want to bring rates back to normal, say 4.5%, then they will have to aggressively sell these bonds to do so. This is why you hear Janet Yellen often talk about the trajectory of rates; they are buying time. To add to this problem, in 2008 the Fed decided to start paying interest on the amount of cash held at the Federal Reserve that is in excess of the reserve requirement for each financial institution. This is referred to as excess reserves. The interest rate is currently set at.50% but moves in tandem with the fed funds rate. So if the Fed decides to raise rates they will also have to pay more interest on excess reserves. The current amount held in excess reserves is around

4 2.3 trillion. So if the Fed increases rates by just.25% the interest they pay on excess reserves increases by 5.7 billion, just another incentive to keep rates lower for longer. ** Long story short- If people would just keep watching the Kardashians and focus more on the Fed s financial statements, it would be clear that rates are likely to remain low for some time Mike Anderson Gray Howard Mike Hicks Vice President Associate Vice President Financial Advisor Portfolio Manager Senior Portfolio Manager Financial Planning Specialist Financial Advisor Financial Advisor Mike.Hicks@ms.com Chartered Retirement Grady.K.Howard@ms.com Planning Counselor Micheal.b.Anderson@ms.com Tiffany Sims Registered Associate Tiffany.sim1@ms.com *federalreserveeducation.org, August 29, 2016 **Federal Reserve.gov, August 2016 DISCLAIMERS. The companies identified within are shown for illustrative purposes only and should not be deemed a recommendation to purchase or sell the companies mentioned. Technical analysis is the study of past price and volume trends of a security in an attempt to predict the security's future price and volume trends. Its limitations include but are not limited to: the lack of fundamental analysis of a security's financial condition, lack of analysis of macro-economic trend forecasts, the bias of the technician's view and the possibility that past participants were not entirely rational in their past purchases or sales of the security being analyzed. Investors using technical analysis should consider these limitations prior to making an investment decision. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley Wealth Management recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. The individuals mentioned as the Portfolio Management Team are Financial Advisors with Morgan Stanley participating in the Morgan Stanley Portfolio Management program. The Portfolio Management program is an investment advisory program in which the client s Financial Advisor invests the client s assets on a discretionary basis in a range of securities. The Portfolio Management program is described in the applicable Morgan Stanley ADV Part 2, available at stanley.com/adv or from your Financial Advisor. Past performance of any security is not a guarantee of future performance. There is no guarantee that this investment strategy will work under all market conditions. Holdings are subject to change daily, so any securities discussed in this profile may or may not be included in your account if you invest in this investment strategy. Do not assume that any holdings mentioned were, or will be, profitable. The performance, holdings, sector weightings, portfolio traits and other data for an actual account may differ from that in this material due to various factors including the size of an account, cash flows within an account, and restrictions on an account.

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