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Gold And Bond Rally Goes On Thanks To The Fed

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Includes: TBT, UGLD
by: Alan Longbon
Summary

The Fed left many things unsaid, but quietly updated its policy statements on its website.

The interest on reserves rates is now effectively the FFR policy rate, and the FFR will sink to 2.35% way balance the 2.5% target.

Fed says the equivalent of Mario Draghi's "whatever it takes" speech.

As has been widely reported, the Fed left the federal funds rate (FFR) at the same rate with no move up or down. There are other changes the Fed makes that are not so widely reported or understood that are just as important.

Here is the fine print from the Fed meeting:

At the conclusion of the January 2019 FOMC meeting, the Federal Reserve issued the following statement that it intends to continue to implement monetary policy in a regime with an ample supply of reserves and in which control over the level of the federal funds rate is exercised primarily through the setting of the Federal Reserve's administered rates.

Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization

After extensive deliberations and thorough review of experience to date, the Committee judges that it is appropriate at this time to provide additional information regarding its plans to implement monetary policy over the longer run. Additionally, the Committee is revising its earlier guidance regarding the conditions under which it could adjust the details of its balance sheet normalization program. Accordingly, all participants agreed to the following:

The Committee intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates, and in which active management of the supply of reserves is not required.

The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

The first part of the notification is that the Fed does not intend to use the FFR to manage the policy rate actively. This means the interest on excess reserves (IOER) of 2.35% is the rate and they have given up active management of the supply of reserves (by buying and selling bonds in the usual way via Primary Dealers).

What they carefully do not say is that the reason they are not relying on the FFR is that they cannot create any bonds to do so and are falling back on the IOER rate as a backstop.

The reason the Fed cannot buy and sell bonds to manage the FFR in the usual way is that the debt ceiling has been reached. This is shown in the table below from the Daily Treasury Statement.

USA daily treasury statement

The IOER acts as a support rate and is a more efficient and economical way of managing an interest rate. This cuts out the Primary Dealers and their fees, charges, and brokerage for placing bonds in the secondary market the government could have placed itself at no cost. No more free lunches for banks for the time being.

One significant addition, almost desperate in its meaning is the last sentence:

Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

This means they would do anything at all to accommodate the economy once the FFR is not effective (zero bound reached). This is similar to EZB Head Mario Draghi's "whatever it takes" speech on the euro during the 2012 'sovereign debt' crisis.

Another critical point is that QT is still set to end in September 2019. The upshot of all of this is that rates go down and bond drought goes on.

One should see the interbank rate drop to 2.35%. The interbank rate is shown in the chart below.

USA interbank rate The chart clearly shows that despite the FFR target being 2.5%, the actual rate is well on its way to 2.35%, which is the IOR and IOER rate. Down to the backstop. The IOR and IOER are shown in the table below.

US FED IOER IOR rates

For investors, this means that the bond (TBT) and gold (UGLD) rally goes on until further notice, as discussed in this article.

Disclosure: I am/we are long UGLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.