Invisible Hand

'Bailouts' Are Misunderstood

Deflation is the current concern not inflation. GDP is falling, unemployment rising, and CPI is falling; this creates deflation not inflation. The combination of the Fed funds rate at virtually zero and CPI falling is another tell tale sign of deflation. I'm not as concerned that we will mimic Japan's deflationary economy because they had and still do have a current account surplus--nation of savers. In contrast we are a current account deficity country, and thus, have no problem with encouraging people to spend as witnessed by our low marginal propensity to save--nation of spenders.

Inflation is a major concern going forward because the Fed always overshoots on the easy money side. Most likely they will start reigning in money supply too late, and this will cause the type of inflation we saw during the late 70's early 80's. I would start dollar cost averaging into tips and gold. You may want to hedge this position with U.S. treasuries. If you have an appetite for risk start building positions in oil and steel in the middle of the year. I figure the fiscal stimuli from around the world should show up in future GDP expectations by then. Moreover, all the pumping of money should start stimulating the world economy.

What Will the Fed Do Now That Rates Are at Zero?

With the 30 year mortgage rate coming down this does show that banks and investors are willing to take some risk. The spread between the 10 year treasury and the 30 year mortgage is still rather high; today it's close to 3%; before the fall season it was at 2.5%; and historically during normal times it's between 1 to 2%.

Eventually we will return to a spread of 2.5%. For this to happen one scenario is that the 10 year bonds would sell off causing its yield to increase, and if mortgage rates would stay constant. The polar opposite would be bond yields staying constant and mortgage rates falling.

If the stock market improves due to the inauguration effect, we should see the first scenario in the short run; bonds sell off when stocks go higher. Inflation worries are another event that could trigger a sell of bonds. I'm not sure how much more mortgage interest rates can fall from here. Fannie and Freddie are supposed to sell MBS in the next week and this should be a tell for mortgage rates.

What Will the Fed Do Now That Rates Are at Zero?

Let me clarify with the info on mortgage rates. Adjustable mortgage rates are based off libor and the 30 year is based off the 10 year treasury. Also there is no 10 year libor..typo. Libor is a short term metric of interest rate risk.

What Will the Fed Do Now That Rates Are at Zero?

Buying properties doesn't bring mortage rates down. Objectively mortgage rates are based off of libor. Generally banks base it off the 10 yr libor and add 200 basis pts or use an average of the 10 year treasury plus 200 basis pts. What creates the libor rate is demand and supply for loanable funds. When the securitization market seized up in sep and october, the supply of loanable funds sharply decreased forcing the cost of borrowing up. Demand also fell but not at the same rate as supply. The avg mortgage rate in sep was 6.04 in Oct it jumped to 6.2. After the Fed made a commitment to purchase MBS from Fannie and Freddie in late October/early Nov. the liquidity "expectations" reemerged dropping rates to its current level.

The Fed funds rate can influence the mortgage rate during healthy times,but during times of financial crisis they don't normally follow as closely. For example, during the last recessin the fed brought the discount rate down, but the mortgage rates didn't reflect this added stimulus.

The Fed is attempting to restore confidence back into the MBS market. They are literally planning on doing this by buying MBS. As you know there is an inverse correlation between bond prices and yields so when the Fed buys MBSs it increases the bond price and lowers the yield on these MBS. The lower yield helps increase confidence and liquidity in the loanable funds market.

With all this said, you can lead a horse to water, but you can't make it drink. On both the consumer and business side, no matter how cheap the cost of money gets, people still need to take risks and not enough people are willing to do this.