How Buyer's Remorse at the Fed Impacts You and Your Investments
02/28/2013 11:00 am EST
Axel Merk of Merk Insights explains how some corners of the Federal Reserve are turning sour about buying so much debt, and how that could affect Treasury holders.
As an increasing number of Federal Reserve Open Market Committee (FOMC) members caution about the dangers of quantitative easing, are we seeing a classic case of buyer's remorse? More importantly, will it return its merchandise? And what are the implications for the economy and the US dollar?
The Fed has what anyone else can only dream of: an unlimited checkbook. The more it spends, the more it earns, as it creates the money to buy Treasuries through the stroke of a keyboard, crediting the accounts of major banks, then receiving the interest of the securities purchased. So why second thoughts?
Is it because what the Fed buys is expensive? The very intent of the Fed's strategy is to inflate Treasury prices, lowering yields.
Investors shall be forgiven for thinking that Treasuries are overpriced. But investors may also be complacent about their Treasury holdings, as long as they believe the buyer of last resort will continue to be the buyer of first resort, thereby providing support to Treasury prices.
Is it because the Fed is faced with a difficult decision? The perceived choice was whether to allow the credit bust to run its course, potentially causing a depression. Perceived, because the choice really started much earlier, as the Fed allowed the credit bubble to inflate in the first place.
But at that time, it was the market, not the Fed doing the buying. The Fed was merely sufficiently "accommodative" to allow others to buy, and when those buyers went on strike, the Fed pitched in with its unlimited checkbook.
Is it because the Fed is questioning whether its goals are achieved? The stated goals are an inflation target of 2% and low unemployment, which have not yet been achieved.
Is it because of the post-purchase evidence? That's where it gets tricky. An increasing number of FOMC minutes are cautioning about the potential dangers of printing $85 billion a month.
Clearly, there are no real bills being printed, but rather accounts of banks credited as Treasuries are purchased. However, that's money on steroids, as physical currency can only be used once by each person, whereas liquidity provided to the banking system may be levered through the rules of fractional reserve banking.
That leveraging up has not happened-the "velocity of money" is still lackluster, as economists say-but concerns about the "exit" strategy have been on the rise.
Which brings us to what ultimately matters: what will the Fed do with this wave of buyer's remorse? The challenge that the success of its strategy, to an extent, depends on the credibility that the Fed will stick to its strategy. That's because especially longer-dated bonds reflect anticipated policy over the longer-term.
That said, we expect Bernanke to reassert his authority, proclaiming that rates will stay low for a considerable period, and that the Fed has little motivation to reduce its bond purchases.
What does it mean for the markets? Despite the volatility in the stock market, the bond market has been peculiarly quiet. In our assessment, containing the bond market is ultimately the primary goal of everything the Fed has been up to in recent years.
However, historically the market, rather than the Fed, controls the long end of the yield curve. That's why the Fed has indicated rates will stay low for an extended period, has purchased bonds, has engaged in Operation Twist, and ultimately has shifted towards targeting employment; suggesting the Fed will not tighten even as economic growth picks up.
For investors, it means they've redeployed some of their money from pricey bonds into pricey stocks, and that suggests that volatility may pick up as different scenarios are priced in more earnestly.
The very active involvement of policymakers in the markets, both at home and abroad, is directly reflected in the US dollar and exchange rates. If Treasuries are at risk and stocks are pricey, currencies might allow investors to find diversification.
Keep in mind that the US dollar historically has often suffered as foreign investors that are large holders of Treasuries de-emphasize bonds, given that bonds may be in a bear market until the next round of tightening.
There appears to be buyer's remorse at the Fed. The real question, however, may be whether investors should have buyer's remorse for holding US Treasuries.