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Cutting Through the Fed U.S. Interest Rate Tightening Claptrap

Interest-Rates / US Interest Rates Jan 08, 2010 - 07:23 AM GMT

By: Mike_Larson


Best Financial Markets Analysis ArticleThere’s a real debate waging on Wall Street. Just like that famous scene from the 1974 movie Chinatown, where Faye Dunaway’s Evelyn Mulwray goes back and forth saying “She’s my daughter … She’s my sister,” today’s pundits keep debating the Fed. “The Fed will tighten” … “The Fed won’t tighten” … “The Fed will tighten” — the commentary shifts with each new data point that crosses the transom.

Me? I’m going to keep things simple. This Federal Reserve, under the guidance of Helicopter Ben Bernanke, will NOT tighten until it has absolutely no other choice.

Forget the day-to-day noise.

Forget the speech-making from Fed governors and board members.

Forget the economic data crossing your screen.

Instead, focus on what is REALLY driving the actions of Bernanke and crew: Fear of the “Double Dip.”

1937-38 on Bernanke’s Brain

The latest economic data leaves no doubt in my mind that the economy is improving. Whether you’re talking about the slowing pace of layoffs … rising auto and retail sales … or the broadest measure of economic output, the GDP, you can see that we’ve put the deepest depths of the recession behind us.

Yes, a good portion of this is because of government spending and stimulus. But it’s still a recovery. And it’s happening at the same time that market-based indicators of inflation fears (TIPS spreads, the yield curve, etc.; I covered them in more detail on November 13) are climbing inexorably higher.

All of this merits a shift in monetary policy. The Fed should start raising short-term interest rates, and more aggressively curtail its emergency support measures.

But the Fed just won’t do it. Instead, policymakers keep going out of their way to stress that nothing is going to change. Fed Governor Elizabeth Duke was just the latest, stressing earlier this week at a Raleigh, N.C. event that …

“The FOMC continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. Such policy accommodation is warranted to provide support for a return over time to more desirable levels of real activity and unemployment in the context of price stability.”

Why? Why the intense resistance to tightening policy?

Bernanke wrote the book on massive money printing.
Bernanke wrote the book on massive money printing.

Look at Chairman Bernanke’s background. Massive money printing is at the heart of his entire philosophy. He literally wrote the book on this subject — the book that’s now essentially the Fed’s operating manual on precisely how to print enough money to overwhelm almost any economic collapse.

Bernanke believes in his heart of hearts that the Fed prematurely hiked rates in 1937, prolonging the Great Depression into 1938 and beyond. He’s convinced that that single, momentous blunder of history is what doomed the world to a nasty “double dip.”

So, yes, the Fed may give lip service to inflation concerns. And it may banter about reducing a few supportive programs at the very periphery of the markets. But Bernanke’s actions speak much louder than his words.

No matter how much he protests … no matter how many new bubbles he creates as a side effect of his easy money policies … he will consistently bend over backwards to avoid raising rates. And he will continue to do everything in his power to pump more and more liquidity into the economy.

Treasury to Torpedo the U.S. Balance Sheet, too!

Ideally you’d have some counterbalancing activity over at Treasury. You’d want to see tighter fiscal policy considering monetary policy is all-out expansionary, or vice versa.

But neither the Obama administration nor Congress is showing any fiscal discipline. They’re coming up with new and interesting ways to torpedo the U.S. balance sheet instead!


It all goes back to the 1937-38 analog. The folks I like to call “Krugmanites” (after New York Times economic columnist Paul Krugman) are in charge in Washington. Krugman warned in a recent column that people like me — those asking for actual rationality in fiscal and monetary policy — are crazy, saying …

“Here’s what’s coming in economic news: The next employment report could show the economy adding jobs for the first time in two years. The next G.D.P. report is likely to show solid growth in late 2009. There will be lots of bullish commentary — and the calls we’re already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder.

“But if those calls are heeded, we’ll be repeating the great mistake of 1937, when the Fed and the Roosevelt administration decided that the Great Depression was over, that it was time for the economy to throw away its crutches. Spending was cut back, monetary policy was tightened — and the economy promptly plunged back into the depths.”

There is zero doubt in my mind that Treasury Secretary Tim Geithner is singing from the same hymnal. So are most other members of President Obama’s economic team and a large contingent in Congress. They’re NOT going to raise taxes and cut spending to get the deficit under control. If anything, they’re going to spend even more borrowed money to stimulate the economy.

Our officials in Washington are showing no signs of fiscal discipline.
Our officials in Washington are showing no signs of fiscal discipline.

What this Means for Your Investments

The philosophical approach that’s dominating Washington policy has obvious investment implications. A few of them:

First, several people have expressed disbelief — or worse — at my call from this past spring that housing was bottoming. They keep saying things along the lines of “as soon as the government curtails its support for housing and mortgages, the market will tank again.”

My response: Forget about what SHOULD happen. Think about what WILL happen. And it’s clear to me the government subsidies are going to continue until the cows come home!

Do you really think the Fed is going to stop buying mortgage backed securities cold turkey on March 31, 2010, if doing so might cause home loan rates to surge?

Do you really think the government is going to force Fannie Mae and Freddie Mac to shrink their mortgage portfolios at a time when everybody’s worried about credit availability?

Do you really think the Federal Housing Administration is going to significantly tighten FHA loan standards when the program is pretty much the only game in town for borrowers with lousy credit and little down payment money?

Of course not!

Fannie Mae, Freddie Mac, and Ginnie Mae — which backs FHA securitizations — now help finance roughly 9 out of 10 U.S. mortgages. The mortgage backed securities market is dramatically overpriced, and being propped up by Fed buying. There is no way in you-know-where Congress, the Fed, or the administration will back away and upset the apple cart.

Expect the Fed’s rock-bottom interest rate policy to drive long-term bond prices lower.
Expect the Fed’s rock-bottom interest rate policy to drive long-term bond prices lower.

So if you’re looking for a renewed plunge in housing as a result of government aid being cut off, forget about it. It ain’t going to happen!

Second, the Fed’s extreme resistance to raising short-term interest rates virtually ensures that long-term inflation expectations will climb. That, in turn, will help drive long-term interest rates higher and long-term bond prices lower.

Last year was the single-worst year for long-term Treasury bonds in decades. If you got hammered in 2009, don’t let 2010 result in more of the same. Consider dumping your long-term government debt (Short-term bills with maturities of three months or less are fine).

Third, consider starting to trim your holdings of long-term junk and corporate bonds, as well as municipals. Shrinking spreads — the difference in yield between non-Treasury bonds and Treasuries of equivalent maturity — have helped offset the impact of rising Treasury rates.

But we’ve already seen extreme spread compression. That tells me we’re in the late innings of this move. I’m also concerned because everybody and his sister has dog-piled into virtually every corner of the bond market.

Their belief? That non-Treasury bonds are impervious to price declines resulting from higher rates. Rest assured they are not. Think about taking some of your profits off the table. Now.

Until next time,


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