Today's Rate Cut

Did anybody really not see this Fed announcement coming today? Really?

Quantitative Easing started on November 21st, when the Fed bailed out Citigroup, not today at 11:20 am. The markets have been rallying since and may soon sell on the “news” announced today by the Fed.

Recap of the Keys of Quantitative Easing (QE) - per Ben Bernanke
I broke down Bernanke’s beliefs about QE in the following post (that post will end up being one of many on the topic of QE) –

http://nbcharts.blogspot.com/2008/12/use-right-tool-for-job-quantitative.html

“When your target interest rate approaches zero, you are forced to use other policy tools to impact economic activity. Bernanke sites three –

- Provide assurances to the financial system that short term rates will be lower in the future than is expected
- Shift the asset mix of the holdings on the Balance Sheet of the Federal Reserve
- Increase the size of the Federal Reserve’s Balance Sheet beyond the level needed to get short term interest rates to zero. This is Quantitative Easing.”

With that in mind, I want to review today’s rate cut press release from the Fed –

“(T)he committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the Federal Funds Rate for some time.” - Point #1 from above

“(O)ver the next few quarters the Federal Reserve will purchase large quantities of agency (Fannie Mae and Freddie Mac) debt and mortgage-backed securities ... it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.”

“Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.” - Point #2 from above

“(S)ustain the size of the Federal Reserve’s balance sheet at a high level.” – Point #3 from above

The Fed really didn’t announce anything new today. Moreover, the markets have been pricing in this new reality for almost a month.

Buy Mortgage Backed Securities
On 11/25, the Fed announced a $500 billion program to buy Mortgage-Backed Securities issued by the US Government Agencies, Freddie Mac and Fannie Mae. The Fed already started buying these securities, weeks before today’s announcement.

The purchase program has brought up a couple of concerns. The primary concern is that if these mortgages are written by US Agencies and carry the “implicit guarantee” of the US Government, then why does the Fed have to print $500 billion in new money to buy some of them?

The answer is two fold. First, if the government completely takes over Freddie and Fannie and issues an “explicit guarantee” for their paper, then the US Government has to move the debt of Freddie and Fannie onto the Balance Sheet of the US Treasury, forcing the US Government to add over $5 trillion to that year’s deficit and over $5 trillion to the US Government Debt total (off balance sheet accounting).

The other concern is that the move is designed to raise the prices on all $5 trillion of the bonds, while they are only threatening to buy $500 billion of them. This is the old “Fractional Banking System Game”, where you act like you have enough money to cover anybody who wants to sell today, but in fact you only have a fraction of the total amount on hand and are really just bluffing.

The concern is then what happens to the prices of mortgages when the Fed spends the $500 billion? About 80% of PIMCO’s flagship mutual fund is invested in US Agency mortgages. Don’t you think they will want to sell a bunch of that junk at a fat premium to the Fed? I know that Foreign Governments are unloading that stuff at a rate of over $20 billion a month. China alone has well in excess of $500 billion in Agency paper.

Buy Credit Card, Automobile and Student Loans
On 11/25, the Fed also pledged $200 billion to buy these loans.

There are two goals to these debt purchase programs of the Fed. The first goal is to take toxic debt off the books of banks at better prices than they would get if they had to sell them at market to decrease their leverage. The second goal is to get lending going again by either getting the banks healthy enough to make new loans, or by having the Fed actually make the loans. The Fed would do so by buying the loans as securities, created by the original lenders – example - General Motors writes a loan to sell a car and sells the loan to the Fed, because these days, nobody else can or wants to buy that loan.

Paul Volcker
Volcker is a former Fed Chairman, who once uttered something to the effect of – eventually you get to a point where you have to make the decision to either crater the currency or crater the economy. Volcker was forced to crater the economy to kill inflation. He did this by raising short to interest rates in excess of 22%. This will occur again in the next 10 years - mark my words.

Now, Bernanke is faces with “curing deflation”. To do so, he will print infinite money and “crater the currency”.

When the Fed’s rate cut was announced today, I heard one of the CNBC guys say “Oh my God, look at the Euro”. The Dollar got killed today (-2.75%). The Euro rallied +3.07% today. The Dollar topped on 11/21 (think Citigroup bailout) and is down -12.5% since. The Euro has rallied 16% over the same period. Silver is up +26.6%.

Remember, asset price appreciation is the primary economic goal of the Fed/Wall Street/US Government crowd, which now controls our country (you can debate me on this if you would like, but my intention is to remain apolitical). So if you have assets, then you should be able to survive the inevitable, massive future inflation wave and interest rate spike.

You will need to get comfortable owning assets like commodities and inflation-adjusted bonds, in addition to stocks. You will also need to be able to own short-term bonds and avoid long-term bonds, because long-term bonds will get trashed when inflation goes up.

So, today’s Fed announcement was more of a confession about the obvious, rather than the announcement of a new policy. The dramatic moves in stocks, commodities and currencies since 11/21 should be retested in the not-so-distant future. I had stops in to buy a few small holdings in Technology (XLK) and Real Estate (XHB) today and my sell them tomorrow. I want to keep my mind fresh for shorting whatever topping process starts to form on this rally from the 11/21 low.