Fed Hints That QE Is Here To Stay; Implications May Continue To Be Bullish For Treasury Bond Prices

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December 7, 2012 4:07pm NYSE:IEF NYSE:SHY

The Daily Capitalist: The Fed is hinting that quantitative easing is here to stay:  there may be no unwinding of its expanding balance sheet in 2015.  Bloomberg.com reports (LINK):

A decision by the Federal Reserve to expand its bond buying next week is likely to prompt policy makers to rewrite their 18-month old blueprint for an exit from record monetary stimulus.

Under the exit strategy, the Fed would start selling bonds in mid-2015 in a bid to return its holdings to pre-crisis proportions in two to three years. An accelerated buildup of assets would also mean a faster pace of sales when the time comes to exit — increasing the risk that a jump in interest rates would crush the economic recovery.

“There is certainly an issue about unwinding the balance sheet” in a way that “is effective and continues to support the recovery without creating inflation,” St. Louis Fed Bank President James Bullard said in an interview in October. The central bank might have to “revisit” the 2011 strategy, he added…

The bigger the balance sheet, “the riskier the exit becomes,” Richmond Fed President Jeffrey Lacker said during a Nov. 20 speech in New York. “That is something we need to think carefully about.”

This is an important news item.

If the U.S. goes into a recognized recession, or turns out to be in one now, likely there will be an extension of the Fed’s zero interest rate policy beyond the current 2015 exit date.  If there is merely slow growth of GDP that, let us say, merely matches the sum of population growth plus productivity gains, then it is reasonable to also assume no shrinkage of the Fed’s balance sheet for some time to come.  In either scenario, the question remains whether the Fed and other central banks are forcing interest rates down that market forces would otherwise send up, or are they mostly following the macro tendency for rates to come down.  As discussed here, these factors range from aging populations and decades of Keynesian policies that have drawn excess production forward, leaving overcapacity in many sectors such as housing, commercial real estate, oil refining, etc.

The latter scenario has been called a “Contained Depression” by the economist David Levy (LINK to article discussing this in detail).  Under this scenario, the “broad shoulders” of the United States and its banking system mean that no matter what the rating agencies say about the U.S. credit rating, the U.S. is de facto precisely what Warren Buffett said:  an AAAA credit.  As regular readers know, beginning in early May of last year, I got onto the “safety first” theme of investing in Treasurys and gold to ride out the difficult times that I thought lay ahead for the U.S. economy.  Dr. Levy further explores these themes in briefer notes titled Long-Term Treasury Bond Fundamentals Remain Strong (LINK) and Safe Assets:  Shrinking Supply and Rising Demand Go Hand-in-Hand (LINK).

Zero-coupon long-term Treasury bonds have two advantage for investors and speculators alike over coupon (par; interest-bearing) Treasury bonds and most municipal bonds.  One is that their total return (if sold) is greater than that of interest-bearing bonds if rates fall.  The other is that if one is planning to re-invest the interest, then there is no re-investment problem in an era in which cash earns nothing and short-term rates might go negative.  Of course, investors in these instruments ought to be prepared to hold until maturity.  Rates can do anything they want.  For homeowners who are worried about stagnation or a new drop in the value of their home, or businesspeople who will benefit should growth and interest rates rise faster than consensus, ownership of a significant amount of longer-term Treasurys provides a reasonable hedge should matters not favor them.

In this scenario, gold is viewed by central banks as a non-callable, infinite duration Treasury bond equivalent.  Over time, its price has correlated both with the aggregate value of Federal debt and has been intrinsically-leveraged to the extent to which interest rates are above or below the Consumer Price Index.  The former argues for upward pressure on the gold:USD ratio.  The latter will vary with CPI trends versus some mix of short- and long-term interest rates.

Because bonds are self-liquidating and gold is not, the above considerations may favor the conservative investor interested in wealth preservation who accepts something akin to the “contained depression” scenario having permanent allocations to Treasurys and not selling until the macro-environment changes (or, never selling), and having a permanent allocation to gold which increases on price dips and decreases on price “rips”.

While many foreign stock markets look attractive, it remains unclear to me why per recent polls the Big Money favors the U.S. stock market.  Its outperformance the last couple of years suggests to me that its prospective multi-year return is mediocre.  Greater prospective growth at lower valuations may be found ex-U.S.

I anticipate that time is needed for the economic wounds of the past to heal, and that the Fed is going to carry a very large balance sheet for a long time to come in playing the role that has been assigned to it.

Related Tickers: ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT),  iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF), ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF), iShares Barclays 20+ Year Treas Bond ETF (NYSEARCA:TLT), Barclays 1-3 Year Treasury Bond ETF (NYSEARCA:SHY).

Written By DoctoRx From The Daily Capitalist

The Daily Capitalist comments on economics, politics, and finance  from a free market perspective. We try to present fresh ideas the reader  would not find in contemporary media. We like to call it  “unconventional wisdom.” Our main influences are from the Austrian  School of economics. Among its leading thinkers are Carl Menger, Ludwig  von Mises, Friedrich von Hayek, and Murray Rothbard. There are many  practitioners of this school today and some of their blogs are shown on  the blogroll. We trace our political philosophy back to Edmund Burke,  David Hume, John Locke, and Thomas Jefferson, to name a few.

Our goal is to challenge contemporary economic thinking, mainly from  those who promote Keynesian economics (almost everyone) and those who  rely on statist solutions to problems. We apply Austrian theory  economics to investments, finance, investment risk, and the business  cycle. We have found that our view has been superior in analyzing and  understanding economic and market forces. We don’t consider ourselves  Democrats or Republicans, right wing or left wing. But rather we seek to  promote free markets and political freedom.

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