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Outlook 2011, Washington & the Fed: KBW Sees Tighter Regulations, Flat Rates

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Federal Reserve monetary policy will keep interest rates unchanged as quantitative easing continues, and regulatory policy out of Washington will continue to pose risks for investors in 2011, said Keefe, Bruyette & Woods analysts at a Dec. 9 outlook breakfast in New York.

Although much of the heavy lifting has already been done in creating a regulatory framework for financial services, the implementation of the rules plus challenges from a new Republican majority will lead to uncertainty about exactly what shape the revised regulatory landscape will take, KBW Washington analyst Brian Gardner said in his research outlook for 2011, “Buy the Regulators; Sell Congress.”

“What’s one person’s technical correction is another’s significant change,” Gardner said at the breakfast, noting that Republicans will push to change elements of the Dodd-Frank bill but won't see much success. “There has been a sigh of relief that Dodd-Frank is in place, but there is still political risk. The Republicans will comb through Dodd-Frank, but it’s not going away. It’s really about the regulators in 2011; it’s a year of implementation.”

Meanwhile, the federal funds rate will remain unchanged through 2011 at the zero percent to 0.25% target established by the Federal Reserve, and the Fed could very well expand past its second round of quantitative easing in 2010 to new QE plans in 2011, according to the analysts on KBW’s North America Equity Research team. Based in New York, KBW is an investment bank that specializes exclusively in the financial services sector.

“We believe that short-term interest rates will remain low during 2011 and through most of 2012,” the KBW analysts wrote in a financial services outlook. “In our view, the ongoing labor market weakness coupled with weakening consumer spending are main reasons the Federal Reserve will hold rates at a low level.”

The Fed will maintain its dovish stance because Chairman Ben Bernanke views the nation’s jobless rate as intolerable, KBW points out. Economic stimulus will continue despite political pressure until a self-sustaining recovery is achieved.

The good news in all of this for investors is that next year will be President Obama’s third in office—and the third year in a presidential term is historically very good for the stock market. Since 1929, on average the Dow Jones industrial average has performed significantly better in the third year of a presidential term than it has done in years one, two and four.

“In our view, this historical trend could be especially important in 2011 for banks that continue to have outstanding Troubled Asset Relief Program (TARP) shares,” Gardner wrote, noting that the U.S. Treasury Dept. currently has about $49 billion remaining in outstanding TARP investments in 593 banks.

“Under the terms of the TARP program, the dividend paid by banks to the government rises from 5% to 9% five years after the shares were sold to the government,” he continued. “For many banks that means in 2013 or 2014 they will need to increase their payment to the Treasury. If we use the presidential cycle as a guide, banks that need to raise equity in order to pay back TARP may find positive conditions in 2011.”

Looking to 2012, KBW forecasts the fed funds rate to increase to 75 basis points in November 2012 and remain at that level through year-end 2012. The forecast lags behind the consensus, which calls for fed funds increases to begin slowly in the fourth quarter of 2011.

See AdvisorOne's Outlook 2011 calendar to find the publishing dates for, and links to, other categories in the Outlook series.


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