Wednesday, March 18, 2009

Quick thoughts on the Fed's mega-stimulus plan

Markets were up today because the Fed announced it was prepared to launch a major initiative to buy up to $2 trillion or so of Treasury bonds, mortgage-backed securities, agency securities, and other asset-backed securities. Wow. Those who still believe in deflation should be heading for the exits pretty soon.

I note that yields on Treasury bonds literally collapsed in the wake of the announcement. I think this is one of those times when the bond market's initial reaction to a big change in monetary policy is wrong. Bond yields fell big-time today, but they won't stay down for long. Ok, so the Fed will buy $300 billion of Treasury bonds, but that's only a small fraction of the amount outstanding, and a lot less than half of what the Treasury will be selling this year to finance the deficit.

Putting things in proper perspective, we're talking big-time stimulus now, and it comes very close to anyone's definition of "helicopter money" which is printed up and shoved out of helicopters flying all over the country. This is ultimately inflationary, and the bond market vigilantes will eventually realize that and push yields higher. (As a corollary to this, we should see gold and commodity prices rise and the dollar fall.) Meanwhile, stocks and corporate bonds should move higher, since this virtually eliminates deflation risk, and that has been a major factor weighing down stocks and corporate bonds for the past several months.

The impact on mortgage rates is tough to predict, because MBS spreads can tighten as Treasury yields move higher. But the Fed's move shouldn't be a big negative for housing in any event, because inflationary monetary policy means the bottom in housing prices will come sooner than otherwise. The prospect of rising home prices should significantly increase demand for mortgage financing. A housing market recovery doesn't need lower mortgage rates; what we need is for buyers to realize that prices have stopped falling. As I've said before, one of the sure signs of an economic recovery would be rising yields on Treasury bonds. That hasn't exactly happened so far, but I suspect it won't take long for animal spirits to revive and prove me right.

I'm not saying that today's Fed announcement is a big positive for stocks and the economy, since I've always believed that inflation was bad for equities and bad for growth. But to the extent that expansive monetary policy eliminates deflation risk at a time that the market is priced to a significant risk of deflation, then I do think it is a positive, but a positive which only helps to reverse an awful lot of negative news. Even if equity prices rise another 20%, they will still be miserably low relative to where they were a year ago.


PD Dennison said...

The Fed appears to be borrowing short and investing long, a classic mistake if rates move higher. I would think the Treasury would be interested in locking in low long-term rates on its borrowing by issuing more 30 year bonds.

I guess the Fed and Treasury assume low rates are here to stay a long time, so they are just speeding up the process of lowing long-term rates.

Scott Grannis said...

The Fed and Treasury are two separate entities. If the Fed buys long bonds and rates go up, they lose. If the Treasury sells long bonds to fund Obama's deficits, they win if rates go up because they have locked in very low borrowing costs. In the short run, government doesn't much care what happens. But the Fed is only going to buy Treasury bonds once; Treasury is going to be selling bonds for as far as the eye can see, so if rates go up because of higher inflation then those who buy the bonds will lose. It's complicated, in short.

zumbador said...

Would you please consider updating the TIPS valuation data. Thank you

Scott Grannis said...

I was doing precisely that when you wrote this question.