I expect the Federal Reserve to announce a program to buy long-term U.S. Treasuries. If not at today’s meeting, then soon. Interestingly, most commentators I read don’t expect the Fed to move in this direction, but to me it seems too easy not to do it.
The Fed’s big fear is deflation. We know the Fed has had the printing presses in high gear for several months now, yet still consumer prices barely move. Today we got CPI, a meager 0.2% over the last year. The cash the Fed is producing isn’t turning into consumption. As I’ve said many times, if consumers don’t spend more money, at least nominally, there can’t be inflation.
Inflation nuts like to complain about the rapid growth of monetary aggregates. M2 for example has risen 9.8% in the last year, or $736 billion dollars. But note that this has almost all translated into excess reserves at banks, which have gone from about $1 billion a year ago, to $622 billion today. In practical terms, money available for consumption is falling.
If the Fed wants to create inflation, it is going to need to overwhelm banks desires for additional excess reserves. That’s going to be very tough given that banks are looking at continued increases in loss reserves (despite Citi/BofA’s claim that they are profitable). BCA is predicting an additional $1 trillion in losses at banks before the credit crisis is over.
To this end, the TALF is great idea. This program aims to stimulate consumer lending directly, bypassing banks, by reinvigorating the asset-backed securitization market. Already Nissan is doing an auto loan securitization tomorrow, and another major manufacturer is going to follow suit this week. These two deals will combine for $5 billion.
That’s all well and good, but it won’t address the problem that consumers might not want to borrow. Household liabilities are currently 134% of disposable income, according to the Fed’s Flow of Funds report. In addition, households have also seen their net worth decline by $13 trillion. Consumers must continue to save aggressively in order to offset these losses. And despite what some Keynesians say, consumers need to have a decent asset base before a lasting recovery can take hold.
But a lasting recovery can’t happen under deflation. Deflation has more destructive power than half the starfleet. Deflation will push home prices even lower, thus exacerbate the problem of negative home equity specifically, and wealth destruction generally.
Currently the Fed is buying Agency debt and Agency mortgage-backed securities (MBS). That program has been a success so far in bringing down spreads on those bonds, especially considering the massive flight away from these securities by foreign buyers.
But that’s just the thing: the Fed has brought down the spread on these bonds. The Fed program has helped prevent mortgage rates from rising in recent weeks as Treasury rates rose. But we won’t see mortgage rates actually fall until Treasury rates fall. Remember that MBS typically have servicing spread of 50bps, meaning that if investors will buy MBS with a 5% coupon, that translates into a 5.5% actual mortgage rate. So if the Fed wants to see mortgage rates at 4.5%, they have to get investors to buy mortgage bonds at 4%. Investors simply aren’t going to buy a mortgage security at a 4% yield if the 10-year Treasury is at 3%.
Forcing Treasury rates lower will be relatively easy. The Bank of England has already set the precedent. On March 5, the Bank of England announced it would be purchasing up to £75 billion in gilts over the next three months. The day after the announcement, even before the first actual purchase, the 10-year Gilt had already fallen by 30bps.
When Treasury yields fall, it puts indirect pressure on all other yields. No other segment of the investing world is so instrumental in pricing so many other investments. The Fed could buy MBS, and bring MBS rates lower, then buy corporates to bring those rates lower, then buy ABS, and munis and CMBS, etc. etc. Or it can just buy Treasury bonds and bring all rates lower at once.
Not only would forcing Treasury yields lower be impactful, it would also easier to achieve. The MBS market is about $8.9 trillion and is made up of thousands of individual securities. By contrast, there is only one 10-year Treasury bond, with about $40 billion outstanding. All the Fed has to do is target the 10-year Treasury and all rates will react substantially from there.
Told ya on the Fed buying long bonds. For once I got a contrarion call right.