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I'm terrified. It looks like Fed Chairman Ben Bernanke plans to run the printing presses until we run out of trees. You can decide for yourself by reading last week’s Federal Open Market Committee statement here, but the part with the numbers is worth quoting:
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.
It looks like the Fed will print an extra $1.15 trillion on top of the almost $1 trillion it has already printed; the Fed has already doubled its balance sheet to $1.9 trillion in the past year. A trillion here, a trillion there, and pretty soon we’re talking about real money. No wonder the reaction to the Fed statement was that everything except the dollar went up: stocks, bonds, gold, even the beleaguered euro.
Dead-cat euro bounce
A euro bounce makes sense in the short term: If you increase the amount of dollars in circulation, the price of dollars should decline. And the price of dollars in terms of other currencies is the exchange rate. But the Fed is after the inflation rate – or the lack of it – since we are currently experiencing deflation or near-deflation on many levels. The Fed is trying to stop deflation from deepening.
I expect competitive devaluations of the same sort from other central banks, so I don't expect the euro to keep rallying given the problems there. But since Bernanke is being so aggressive, and the Europeans in general are more conservative, you never know. For the time being, the Euro can rally, but I don't expect it to go far. I still maintain my ultimate target of 1:1 for the dollar/euro exchange rate, as this is a confederate currency with no unified Treasury department, and the weaker economic parts of the confederacy are under severe stress. To trade the euro, you can use the Currency Shares Euro Trust.
Bonds are for real
The bond market had a huge move on the heels of the news that the Fed will buy $300 billion worth of longer-term Treasury securities. The 10-year note saw its yield decline from a high of 3.02% in the morning to a low of 2.47% in the afternoon of the FOMC announcement. The Fed managed to shave half a percent off long-term interest rates.
This is where it gets tricky. If the market is worried about inflation, can the Fed keep long-term interest rates in check? Theoretically, the answer should be no. You can't have your cake and eat it, too. You may want to create inflation – which is what the Fed wants now – but you will have to pay for that with higher interest rates.
As I have opined before, there is a fundamental difference between money and credit. This is why the call to buy long-dated Treasuries made in early March is beginning to work out. In my opinion, the credit conditions have tightened much further than the Fed expected, and therefore printing is not causing inflation. I still think that the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT ) has room to run to the upside, despite all this printing. It will be very difficult to repair the broken credit mechanism, in my view, as the securitization game that perpetuated it is now over. It's that simple.
If, however, you worry about inflation, you can buy long-dated Treasury Inflation Protected Securities via the Barclays TIPS Bond Fund. The average maturity is nine years, and the bonds' principals are in effect indexed for inflation. If inflation is a problem, the principal of the bond will be indexed higher, and you will receive the fixed coupon interest calculated on that higher inflation-indexed principal amount.
Gold works either way
The gold market, too, had a huge move on the Fed news. It makes sense: $1.15 trillion in crispy dollar bills will hit the market in 2009, but there’s still a nearly fixed amount of gold on the market -- the price of gold has to go up. One favorite way to play this is via the SPDR Goldshares (NYSE: GLD ) fund, which trade at 1/10 the price of gold. (For more leveraged ways to play the gold market, see this more detailed article.)
Gold works in both inflationary and deflationary environments. It does not work when times are good and no one is worried about the stability of the financial system. I think it's safe to say the environment is perfect for gold at this point. The gold price is flirting with $1,000 an ounce on the FOMC news. The next time it crosses $1,000, it will stay above that level, in my opinion. The days of cheap gold are over.
The worse the bank stock, the more it's risen. Citigroup (NYSE: C ) went from $1 to $3, Bank of America (NYSE: BAC ) went from $3 to $8.50 … you get the picture. But those stocks are still down a lot for the year. It is a lot better to own stock in the winners in the banking space, like JPMorgan (NYSE: JPM ) , Goldman Sachs (NYSE: GS ) and Morgan Stanley (NYSE: MS ) (those last two are now bank holding companies). Banks with relatively strong balance sheets will not go up as much in a rally, but they certainly will not go down as much in a sell-off. And for long-term investors, protecting their assets has been of utmost importance in the past year.
In my view, the moves in gold and bonds are for real, but stay away from euros and weak banks. This type of massive quantitative Fed easing has never been tried before, and I fear that Bernanke may be going out on a limb. Stay defensive.
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