The Fed – today, tomorrow and next year

November 4, 2010

The event world financial markets had been waiting weeks for finally arrived at 11:15am (PST) today and as I had written gave us almost exactly what was expected with its expanded Treasury purchase plan. After carefully studying every speech and research paper written by Fed Chairman Bernanake it wasn’t difficult to forecast the size and timing of the QE2 program unveiled this morning. The Fed statement referenced the current low inflation rate (twice) and then said it wants to “ensure that inflation over time is at levels consistent with its mandate (2%).”  It will purchase Treasuries at a pace of $75 billion per month (new money) and add another $35 billion per month that comes from bonds and notes that mature or pay coupons to make sure every newly printed dollar goes directly into the banking system. I warned of problems in the long end of the yield curve (30 years) and despite many “experts” believing the Fed would extend purchases into this area Ben had told us in speeches from 2002 the Fed would stay in the 10 year and under range. 94% of purchases will be for maturities of 10 years or less and the news sent the 30 year bond up 15 basis points in less than an hour. The best part of the curve after the announcement was the 5 year which fell 8bp. One of my favorite leading indicators is the spread between the 10 year and 30 year Treasuries and it reached new highs this afternoon at 147bp.

The upcoming battle between the Fed and the markets

The long end of the yield curve is a battle that has just begun with inflationary expectations rising because the Fed is trying hard to manufacture inflation while they are also trying hard to push down long term interest rates. Since interest rates are composed of a real rate and an inflationary component the Fed is attempting to walk a fine line between lower long term rates that will encourage borrowing and a Fed induced rise in inflation that should push long rates higher. Normally long term interest rate markets move to the signs of inflation and economic growth but the Fed is about to become the dominant and maybe only player in the market. The 35% limit on purchases of each Treasury issue will soon be abolished because the amount of Treasury issuance in the next six months will barely exceed the amount of purchases by the Fed.

Using recent Treasury auction data and estimating Treasury cash needs for the next five months it appears the government will issue approx $585 billion (net) of securities versus $550 of purchases by the Fed leaving very little for anyone else to buy. Of course there are other “older” already issued Treasuries that trade every day but the older the security the less it trades and the Fed has always stayed away from thinly traded issues. The bottom line is it will be very difficult for interest rates in the 10 year and under sector to rise and most likely Fed buying will cap the rates at recent levels.

The good, bad and what could be very ugly

The best news comes for borrowers that can qualify for a loan as rates for fixed rate terms of five years and under will remain at record lows. Despite mortgage brokers and real estate agents plea’s that rates can only rise the Fed will make sure the short end of the yield curve stays anchored and since they own the printing press short rates won’t rise until the Fed stops buying.

The bad news comes from overseas where China, Japan, India and other countries will now have an easy exit from their Treasury holdings as the Fed will soon be the owner of almost all of our Treasury debt and if and when they decide to exit (not soon) it will be faced with the age old question of “sell to whom?” as it will take much higher rates for foreign countries to come back to the Treasury market after exiting at record high prices. Since the creation of hundreds of billions of dollars will send the value of the dollar plummeting foreigners will have little reason to hold Treasuries that yield little but fall in value when converted back to their home currency. Gold is sure to be the beneficiary of a falling dollar as other countries are not going to be happy about sitting back and watching their currencies soar upward and making goods and services more expensive to the outside world. It is highly doubtful the rest of the world is going to not fight back in the currency markets.

The ugly could be the downfall of the Fed’s policy since creating money almost never creates new jobs. The newly created dollars will seep out of the banking system sending stock prices higher but also commodity prices and that will hurt the average consumer whose wages will never keep up with higher food prices and energy prices. The Fed will receive little if any assistance from fiscal policy after Tuesday’s election results that investors are cheering because gridlock implies less interference from the government. Gridlock is good when the economy is growing but when the economy is trying to find a bottom tax cuts, less government red tape for new businesses and other stimulants are needed to incentivize expansion and new hiring.

As usual it is kick the can down the street policy that dominates today and the Fed is using the only tool it has to try and jump start consumer confidence by printing money that is used to send equity prices higher. What the Fed wants it will get with higher commodity prices but it won’t be able to sell its Treasuries because once they stop buying there will be an air pocket below with few if any buyers except at much higher rates and lower prices. I’m surprised the Fed isn’t using some of the newly printed money to buy houses because that would help more people than rising equity prices. Why not spend a few billion and buy all of the foreclosed houses waiting for a buyer and then rent them at a low rate to previous homeowners? It would be cheaper than throwing billions at the banks who are speculating in stocks and at the same time it would help the banks repair their balance sheets. It’s too simple for the Fed and they would need the approval of too many parts of the federal government.

Stocks – update

The equity market continued its recent string of less than 1% change days (10) and the S&P has now risen 8 out of the last 10 days. The Fed’s newly printed $$$ will go into the banking system each month and since they have been making $$ buying stocks there is no reason to believe they won’t continue since we only see the future from our own past experiences. With enough new money stocks could easily soar to new all time highs but the real winner from this new policy is gold which continues to appreciate against ALL world currencies and with rates remaining low the cost of holding the yellow metal is near zero. If a currency war begins (it will next year) gold will be the safe haven of choice for investors worried about the value of their own currencies.

Volatility is sure to come back soon and investors must be very careful to only buy into periods of weakness and sell into strength. Any signs of a job recovery next year will send long rates higher on the expectation of a Fed exit but they will err on the side of waiting until they are 100% sure of an economic recovery and that won’t occur for at least a few more years.

Before entering any investment, everyone should consult with their own investment professional and discuss the risk of possible loss of capital.