Fed's Bond Buy Signals Crisis

Stocks are rallying, bonds are soaring, and your mortgage rate could fall again now that the Federal Reserve has agreed to take on billions worth of new Treasuries and other securities to support the ailing economy.

Don't be fooled: The Fed's decision is a reason to worry.

The decision yesterday to buy $300 billion worth of long-term Treasuries over the next six months and expand existing lending programs by another $750 billion is actually a little scary. Precisely this sort of action was long considered a last-resort arrow in the Fed's quiver. But as the Fed said in its statement, the economy has continued to contract since January. With interest rates close to zero and available options dwindling, the Fed's move simply shows central bankers think the crisis is continuing.

As it has all along, the Fed has said it will act as needed to head off this recession. The question is, are we now finally approaching the point where as-needed becomes if-possible? With this move, the Fed's balance sheet is likely to pass the $2 trillion mark, and at some point the ability of the Fed to pour additional stimulus into the economy will run out.

Markets like this commitment by the Fed to bring down borrowing rates quickly and decisively. The bond market surged, with 10-year Treasuries climbing and yields sinking below 2.6 percent from around 3 percent on Tuesday. As Nigel Gault at IHS Global Insight put it, "The good news is that the Fed is firing all its weapons at the recession. The bad news is that the recession is severe enough that all weapons are needed."

The resulting faith-based rally could indeed mean we're nearing a moment of truth where the crisis turns a corner and monetary and fiscal efforts finally pay off. That should focus investors and regulators on making sure the plans in place work as advertised -- another reason to step back from yesterday's grandstanding over AIG bonuses and calling for Treasury Secretary Tim Geithner's head. The systemic problems in the banking system and the economy still have to be fixed, and the longer the wait (on the TALF, on pricing bad assets, on forming a working public-private partnership to get lending flowing) the worse off we'll all be.

Further out, we could look back and see this as the point where the Fed drew a line in the sand in its efforts to reverse the effects of the credit crisis. (What comes later, including the threat of inflation and a weaker dollar from the Fed's unprecedented borrowing, are worth a mention too). Also, part of the reason for the buying may be the fact that other key customers for American debt (i.e. the Chinese) are losing interest, as Brad Setser points out here.

In all, investors looking for a sustained equity rally could be disappointed. The Fed's actions may be correct, but that doesn't mean they should be comforting. Doing everything possible to put out a fire only matters if the fire goes out.

The Fed's statement is here.

Comments

[J. D. Swampfox:]

The Fed's never-in-the-history-o... actions in response to a never-in-the-history-o... no-end-in-sight-crisis....it's definitely not clear whether this "good" or "bad"...

Mar 19 06:59 AM

[Truefire:]

Dance as they may. There will be no recovery until the credit default swap situation is resolved.

"Pay no attention to the man behind the curtain". That didn't work in the Wizard of Oz & it won't work here.

Stop the Bull S**T & get on with it. Cancel all the naked credit default swaps (parties with no material interest) . Short of doing this will lead the reasonable man to assume that this is a controlled, calculated looting of the public coffers.

Mar 19 07:19 AM

[atlasman:]

I am sorry, but .25-.5 reduction in mortgage rates is just not worth loading the FedsB/S up in this way. If you are responsible and pay meet your obligations, you can get a car or house loan on reasonable terms.

Mar 19 08:01 AM

[normthefedup:]

Good points author. This isn't the cavalry coming over the hill to save us, this is the last ditch nuking of the enemy with the hope he stops coming. And I have a bad feeling we've run out of nukes. Always the optimist, here's hoping for all our sakes that this is the extended hand that keeps us from falling off the cliff. Interest rates at 4%? Just wait'll you see them (not to mention the accompanying inflation) in about 3 years or so. For those of you, like me, who lived, worked, and endured the 70's and 80's, here we go again. Save your money, you're going to need it. Amen.

Mar 19 08:20 AM

[Dave Wrixon:]

This is a battle they could never have one, primarily because it is a problem that they have yet to understand.

Mar 19 08:32 AM

[prudentinve...:]

Increased inflation is coming to food, fuel, and consumer goods, but not to wages. The consumer is already maxed out and inflation will lead to even further retrenchment. This cannot be good for stocks or commercial real estate.

Mar 19 08:35 AM

[foxy 44:]

I think the main reason is, anybody accross the world want to buy anymore US T-Bonds.

Mar 19 08:49 AM

[change is t...:]

We have inflationary monetary policy, delevering hedge funds, overlevered banks, decreasing wages and employment, one step away from bankruptcy industrials and extreme fiscal stimulus. Did I mention a global recession and oversupply of many manufactured products too? Is anything missing? Oh, the housing collapse!

So, this means we will have inflation competeting with deflation, overpriced assets competeing with underpriced assets, and finally, credit shrinkage competing with liquid surpluses.

What does this mean? Crisis?

How does that song from Casablanca go? You must remember this.....A kiss is just a kiss...... a sigh is just a sigh.......the fundamental things apply, as time goes by.



Greed and fear still work. Great article.

Mar 19 09:21 AM

[robert.b.fe...:]

Good article. I coulden't get my head around what the fed was/is doing. Now it appears that they are just desperate. Sooner or later they will have to bite the bullet and take the bad paper off the bank ballance sheets. As long as all of the bad debt is hanging over the markets like the sword of Damoclese things won't stablize. Get ready for another dip and hope that the new floor holds. If it dosen't even worse things will be around the corner.

Mar 19 09:46 AM

[sleepless_o...:]

As skeptical as I am that the Fed can turn things around before the entire financial web is unwound and something close to a laissez-faire bottom is reached, I am reminded of an old saying: "Don't fight the Fed."

Mar 19 09:50 AM

[pacman1947:]

Kirk,
I agree with Change is the only constant, "Greed and fear still work."

I only add a line from the Eagles song, "There ain't no way to hide those lying eyes."

The Fed has performed a dangerous maneuver. The real question is whether we are now in extremis -- a collision with our fate is imminent and unstoppable. It may no longer matter what they do.

Mar 19 10:00 AM

[Larrysyr:]

The cure for the crisis is drastic. We're likely to have an overshoot on the inflationary side, followed by an engineered recession to bring that under control. It won't be pretty. It won't be fun.

Maybe we'll get through this without widespread shortages, riots, etc. Maybe not. But I suspect the Fed and the administration calculated the risks and figured this was the least bad course they could take.

It's like putting a heroin addict on methadone. You still have an underlying addiction to deal with.

We know how to handle inflation/stagflation a lot better than a deflationary depression. But it won't be easy or quick.

Mar 19 10:53 AM

[Vox Rationalis:]

"...the Fed's move simply shows central bankers think the crisis is continuing."

This is reason to worry? Isn't this already fairly well-established conventional thinking?

"Also, part of the reason for the buying may be the fact that other key customers for American debt (i.e. the Chinese) are losing interest, as Brad Setser points out here."

China holds less than 7% of our debt, and as its trade surplus declines it can buy fewer foreign assets, including US debt. This truth doesn't have anything to do with the relative "worth" of US debt.

Don't forget that the largest buyer and holder of US debt is Social Security - in other words (and yes, I do mean to scream) WE'VE BEEN BUYING OUR OWN DEBT FOR YEARS. This is just a new agency doing it on a somewhat larger scale (SS added $180B last FY).

"Doing everything possible to put out a fire only matters if the fire goes out."

And saying that we're doing everything we can only matters if we are in fact doing everything we can. I see no reason to think that we've reached the limit.

Mar 19 11:49 AM

[Andy Abraham:]

I would not say worry... but have a plan... you do not need to be a victim of this mess... diversify your assets... corn...gold...and all other commodities can not go to zero...people still will need to eat...
Learn about what happened in the Great Depression...learn from history... one of the facts was the US dollar fell 40%. Go for real assets... be flexible... don't fall in love with whatever investment... such as gold... Learn to trend follow with a strong focus on risk...

Mar 19 12:16 PM

[carey_jim:]

The famous bottom line is this: Action by the Federal Government is not always either beneficial or effective and there are often unintended consequences.

Examples: The war in Iraq, school busing and rent control to mention only a few.

Increasing the money supply might cause more than inflation. In an atmosphere of international trade, it might precipitate trade barriers and competitive currency devaluations.

If our financial future could be predicted with the ease of a simple algebraic equation, Prices = Money Supply * velocity, we would all be rich.

Mar 19 12:41 PM

[robert.b.fe...:]

I completely agree. Team Obama curtailed Mexican transit allowed under NAFTA (probably a boon to the Teamsters union) and now the Mexican government is taking steps to retaliate. Just what we needed on top of all the rest of the mess. A trade war with Mexico


On Mar 19 12:41 PM carey_jim wrote:

> The famous bottom line is this: Action by the Federal Government
> is not always either beneficial or effective and there are often
> unintended consequences.
>
> Examples: The war in Iraq, school busing and rent control to mention
> only a few.
>
> Increasing the money supply might cause more than inflation. In an
> atmosphere of international trade, it might precipitate trade barriers
> and competitive currency devaluations.
>
> If our financial future could be predicted with the ease of a simple
> algebraic equation, Prices = Money Supply * velocity, we would all
> be rich.

Mar 19 12:56 PM

[dcb:]

I wrote my senator and congress man and asked why in the war in terror the white house could make up the data that drove us into Iraq, imprison people for as long as they want without trial, and engage in domestic spying. Yet in the financial war we are engaged in the white house can't cancel derivative contracts, or get bonus money back?

Mar 19 02:35 PM

[dcb:]

Unfortunately, the average american doesn't have the funds or knowledge to protect themselves from the actions of the fed and are stuck. These are the people I worry about, whie the fed does everything they can to transfer money back to the wealthy who lost it.


On Mar 19 12:16 PM Andy Abraham wrote:

> I would not say worry... but have a plan... you do not need to be
> a victim of this mess... diversify your assets... corn...gold...and
> all other commodities can not go to zero...people still will need
> to eat...
> Learn about what happened in the Great Depression...learn from history...
> one of the facts was the US dollar fell 40%. Go for real assets...
> be flexible... don't fall in love with whatever investment... such
> as gold... Learn to trend follow with a strong focus on risk...

Mar 19 02:38 PM

[hpcooperjon:]

There's a pattern here. If one is willing to look. The Amero is coming? Because of the dollar collapse, because of the Treasury purchases by the Fed, because of the collapse of the financial industry, because of the subprime debacle with resulting CDS (say you spell fraud?), because government LET IT HAPPEN!, because "they" want it to happen. Who are "they"? If you don't already know where have you been hiding? Post-Amero; Amero replaces all world currencies? Man of Peace emerges to lead world into a new era. "They" think. Maybe not.

Mar 19 03:03 PM

[PainfullyAware:]

August 20, 2009

Almost At The 300 Billion T-Bond Limit for The Fed.

Still No End To The "Calamity" In Sight.

I Would Bet The Fed Raises Its "Limit".

The Lunacy Continues.

Aug 20 04:09 AM