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When the Fed Stops the Music

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The quantitative-easing program ends in March. Then what?

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Last week we delved into the uncertainties that face us and that make forecasting for 2010 problematical. Will the government actually increase taxes as much as they say, with unemployment still likely to be at 10%, or will cooler heads prevail? Would such an increase cause a recession? Will the markets anticipate the effects of such a major increase in advance? How will the mortgage market react when the Fed stops buying mortgage securities at the end of March? There are so many things in the air, and today we explore more of them, as I continue (perhaps foolishly) to try and peer into what is a very cloudy crystal ball.

When the Fed Stops the Music


The Federal Reserve has been very clear about the fact that they intend to stop the quantitative-easing program at the end of March. What that means in practice is that they're going to stop buying mortgage securities. That does two things. As Bill Gross so aptly points out, those mortgage purchases helped keep mortgage rates low. But they also financed the US government fiscal deficit, albeit indirectly. It seems that funds and banks that sold the mortgage securities turned around and bought US government debt or put the cash right back at the Fed.

Foreigners bought about $300 billion of the $1.5 trillion in new government debt. The rest came from the US, courtesy of the Fed buying mortgages. But that program stops (theoretically) at the end of March. The government still plans to run yet another $1.4-trillion-dollar deficit (give or take a few hundred billion). The question is, who will buy the debt? Foreigners will kick in another $300 billion, unless they decide to stop selling us stuff, or buy other less liquid or physical assets. So far there's no sign of that.

But as I asked last year, who's going to buy the multiple trillions in government debt that the G-7 countries want to issue? Who's going to buy another $1 trillion here in just the US? That is 7% of GDP. That means that consumers and businesses will have to save an additional 7% of GDP just to finance government debt at the federal level, not counting state and local debt. As Bill Gross concludes in his recent column (www.pimco.com):

The fact is that investors, much like national citizens, need to be vigilant, and there has been a decided lack of vigilance in recent years from both camps in the US. While we may not have much of a vote between political parties, in the investment world we do have a choice of airlines and some of those national planes may have elevated their bond and other asset markets on the wings of central bank check writing over the past 12 months. Downdrafts and discipline lie ahead for governments and investor portfolios alike. While my own Pollyannish advocacy of "check-free" elections may be quixotic, the shifting of private investment dollars to more fiscally responsible government bond markets may make for a very real outcome in 2010 and beyond. Additionally, if exit strategies proceed as planned, all US and UK asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this "juice" was being squeezed into financial markets. If so, then most "carry" trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their "sugar daddy."


This is yet another uncertainty. We simply have no idea, no relevant marker, for what happens when a country goes so cold turkey, coming off a central bank bond-buying binge. And this in the midst of a massive deleveraging, and with stock market valuations basically where they were in 1987 -- except there was at least large earnings growth then.

No positions in stocks mentioned.

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