Federal Reserve Goes ‘All In’ and China Calls

Last week, the Federal Reserve announced it would begin buying “the long end of the yield curve”.  What does this mean exactly?

On March 18, the Federal Reserve announced it would spend up to $1 trillion to buy treasury notes and mortgage securities.  (Source:  Bloomberg, March 19, 2009)

According to an article published yesterday on Bloomberg, the Federal Reserve will focus on buying US Treasuries with maturities of 2 to 10 years and spend up to $300 billion to do so over the next 6 months.  In addition, the same article suggests the fed will also increase its buying of mortgage backed bonds issued by government backed entities like Fannie Mae and Freddie Mac from the current commitment of $500 billion (made last fall) to as much as $1.25 trillion.

This move by the fed last week sparked the largest drop in Treasury yields since 1962. (Source:  Bloomberg March 19, 2009)  This means the selling price of Treasuries went up since bond yields and prices move inversely.

Where is the Federal Reserve getting this money?

It’s simply printing it.  The fed wants to keep bond prices high and interest rates low in an attempt to revive lending, so it has now becoming the buyer for these securities.

Short term, the stock markets reacted positively, which was not surprising, but at the same time as the stock markets were rallying, so was gold and so were other currencies that go against the dollar.

It was a bold move for the fed.  With the fed funds target interest rate at 0% - .25%, the fed couldn’t reduce interest rates further in order to try to get more money flowing into the economy.  So in an unprecedented move, the fed elected to buy back government debt with freshly printed money.

If you’re a poker player, this move by the fed might be described as going ‘all in’.  When the fed is buying government debt and replacing it with even more debt, the end result is something known as monetizing the money supply, or, as the fed prefers to call it, ‘quantitative easing’.  Simply put, the fed is creating US Dollars almost from thin air.

The result?

As noted above, the US Dollar fell and gold prices rose.

China, however, didn’t view the move by the fed as positively as the equity markets did.  In an article published on Fox News (March 24, 2009), China’s central bank governor called for the creation of a new currency to replace the US Dollar as the world reserve currency.  The suggestion was part of a sweeping proposal to overhaul global finances and reflects how unhappy China and other developing nations are with the US’s role in the global economy.

Russia agrees with China.  Earlier this month, while preparing for the G20 meeting, Russia went on record recommending that the International Monetary Fund issue the new world reserve currency, and noted the need to “update the obsolescent uni-polar world economic order”.

More freshly printed dollars will likely devalue the dollars already in existence, a problem for any nation who holds US dollars in reserves.  However, for the US Government, with no real reserves, devaluing the dollar allows for repayment of debt with dollars that are worth less than the dollars under which the debt was accumulated.  The end result (in my opinion) is a “worldwide poker game” with billion, even trillion dollar stakes.

How might this affect US citizens?

If the feds recent action creates the liquidity it wants, it’s my view that inflation, perhaps even hyper inflation could potentially soon follow.  If this happens, those at the lower end of the economic scale may likely be affected, spending a greater percentage of their incomes just for necessities and reducing the dollars available for discretionary spending, creating another potential drag on the economy.

If you have accumulated wealth, it’s my view that you need to look at dollar alternative investments and absolute returns* investment strategies.

For more information and my current market update visit www.usawealthmanagement.com.

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* Absolute return investment strategies aim to produce a positive return regardless of the directions of the financial markets by investing in cash or other low volatility investments and then taking hedged long and/or short positions in securities that when combined are expected to have modest exposures to market returns.  No investment strategy is 100% accurate.   Investing in market related securities involves a risk of principal loss. Prior to making any investment decision, the services of an appropriate professional should be sought as investment related recommendations are dependent upon the personal financial situation of each individual investor.