FOMC Statement: Skeptical This Will Work

by: David Merkel, CFA

Below you will see my summary of the FOMC Statement and how it changed. Before I give you that, let me summarize what I think the changes are, the market impact, and whether I think it will work.

The Changes

  • The Fed will expand its balance sheet massively, buying another $750 billion of agency mortgage-backed securities, $300 billion of long Treasuries, another $100 billion of Agencies, and expand eligible collateral for the TALF to include who knows what.
  • The crisis involves the real economy in a big way now, not just the financial economy.
  • The crisis is definitely global.
  • They have ceased to forecast when it will end.
  • They are pursuing recovery, not growth now.

The Market Impact

  • The Dollar fell roughly 2-3%. Gold rallied 4%+.
  • The ten-year sector of the nominal Treasury curve fell the most in yield terms, around 50 basis points. Biggest rally since 1962. The long end fell 30 basis points. Agencies outperformed Treasuries. Mortgages lagged.
  • TIPS outperformed nominal bonds with the long end falling 40 basis points, and the 10-year 55 basis points, leading inflation expectations to rise.

Will this work?

I’m skeptical. This is just a bigger shift of financial obligations from the balance sheet of financials to the Fed, at prices unfavorable to the Fed, because their own statements will make them buy dearly. When they unwind these trades, they will take significant losses, eliminating seniorage income to the US Treasury.

Lowering Treasury, Agency and conforming mortgage rates, assuming that it can be done in the long run (not likely), will not help consumers or corporations. Forcing a small spectrum of interest rates down does little for collateral values. People are inverted on their debts, and this does not solve that. You might get a few refinances out of that, but that’s all. Credit card, auto, and other debts are unaffected, and the TALF is still pie-in-the-sky. Can it work? Corporate bonds, bank debt, Commercial real estate loans, etc. – there is no effect. It only makes life better for the US Government, Fannie, Freddie, the FHLB, and those seeking conforming mortgage loans.

There is no real debt reduction here, and debt levels are the cause of this crisis, not interest rates on the debt. I don’t think this will work, but this is another case where “the beatings will continue until morale improves.” Ben Bernanke is too certain of what is the correct move, given his Ph.D. studies. It would be better and simpler to follow an inflationary course that hits at the root causes of debt by giving every adult a $5,000 voucher good to pay off a debt to any regulated financial institution. Consumers win, banks win, and foreign creditors lose.

Current Recommendation

I don’t think this rally will hold, so when upward momentum fails, sell long duration fixed income positions.

Fed Statements Compared

I reordered the January Statement to make them compare better. Click to enlarge:Click to enlarge

Click to enlarge