Published January 27, 2012

Is the Fed Cranking Up the Presses Again?

Dear Reader,

Vedran Vuk here, filling in for David Galland. Today we'll cover a number of topics, most importantly Bud Conrad's coverage of the Fed's announcement on Wednesday. For a while, investors were basically allowed to sleep through these Federal Open Market Committee statements – we get it; they're keeping rates low. However, this meeting had a few key points that should stir investors from their slumber. I'll start with a discussion about the weakening core of European nations. Then I'll return to touch on other topics of interest.

Cracks in the European Core

By Vedran Vuk, Senior Analyst

While the euro crisis has taken a momentary breather, let's not forget the even bigger dangers on the horizon. We've all seen the spreads between the PIIGS and German bonds. Needless to say, they aren't pretty. But another chart is scaring me even more at the moment: It's the 10-year bond spread between Germany and France:

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The media always want to frame financial news in the classical sense: the good guys versus the bad guys. In this case, it's the responsible and prudent core of Europe versus the lazy and uncontrollable PIIGS. However, the chart above tells a different story. The crisis has reached the core itself. Rather than being an impenetrable fortress, countries such as France have their own problems.

That should come as no surprise. The rest of Europe has been following the exact same path as Greece, Portugal, Spain, and all the other "bad guys." It's the same story of excessive spending programs, disastrous labor laws, and widespread government interventions. In fact, the European core must necessarily experience the same problems. If you're following the same stupid policies, you should expect the same bad results. It's logically inconsistent to think that certain policies are absolute failures in Greece while they magically work in France.

The only difference is that the core countries have been able to afford their programs thus far. Countries such as Greece aren't following a unique Greek policy agenda. Instead, Greece essentially tried to mimic Western European policies on an Eastern European budget. Unfortunately, that just doesn't work… but those policies won't work for Western Europe in the long run either.

Now don't get me wrong: I'm not saying that France or some of the other core countries are going into a crisis. I'm just pointing out that the cracks are starting show. If Europe can't shake its obsession with the welfare state, I have little doubt that some of the biggest European countries will be the PIIGS of tomorrow. They're walking the same path as Greece, Ireland, Italy, and Portugal. But because of their stronger economies, they are taking this stroll at a much slower pace while the PIIGS are sprinting toward the end of the road… and the cliff waiting there. Though one country is running for the cliff and the other is walking, make no mistake – they're both on the exact same path.

But let's put this in perspective for now. The spread over German bonds is a little above one percent. This isn't the end of the world. In fact, it's very far from it, and considering all the problems in Europe, I'd still much rather hold French bonds than many other options. However, there are a few important things to take away from this situation. The spread between French and German bonds can teach us an important lesson about US interest rates.

For years, the spread was almost nonexistent at less than half a percent. Then investors got just a little worried and within months, the spread widened. The exact same thing can happen with US interest rates. We at Casey Research have often mentioned the possibility of rising rates as a result of inflation kicking in, the Fed raising interest rates, or investors losing faith in the US. To some people, these sound like doom-and-gloom scenarios. In some ways, yes, they are; but you don't need a major event to send interest rates upward.

Suppose investors become a little concerned about the United States – just like they're a little worried about France at the moment. No one is saying that the end is near or that utter ruin and collapse is just around the next quarter. Instead, imagine just enough worry to send ten-year interest rates jumping from 2% to 3% in a matter of months. We're not talking about a herculean leap from 2% to 7% or a sudden default crisis. Instead, this would be a small move, and it's far from a radical prediction. Unfortunately, for many bond investors flirting with longer-maturity bonds, even this one percent move could hurt. If this is already happening between the spread of two "safe" European countries, it can happen here as well.

The media condition us to not think in shades of gray. And you can understand their perspective. The half-a-percentage-point spread increase between German and French bonds isn't exactly shocking, copy-selling material. As a result, the media like to frame the European core as strong and PIIGS as foolish and weak. In reality, there's less difference between them than you may think. Similarly, we're often told that US Treasures are perfect AAA investments, or that they're in the danger of defaulting within years. The trouble is that while paying attention to the extremes, a whole lot can happen in the middle – and that action can be just as destructive to an unprepared portfolio.

The Fed Returns to Printing

By Bud Conrad, Chief Economist

On January 25, the Federal Reserve announced important policy changes after its Federal Open Market Committee (FOMC) meeting. Here are the three most important takeaways, in its own words:

  1. The Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions – including low rates of resource utilization and a subdued outlook for inflation over the medium run – are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
  2. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. In the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent.
  3. The Fed released FOMC participants' target federal funds rate for the next few years.

Immediate Reactions

The first item is the most important as it was not expected – and it had an immediate effect on markets. As seen in the chart below, gold spiked higher on the surprise news of extending the zero-rate policy through 2014.

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The news prompted a similar jump in silver services:

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Keeping rates low requires the Fed to print new money to buy Treasuries, so the dollar weakened against the euro, although the reaction wasn't as big as in those in the gold and silver markets. This is partially due to the fact that the ECB is on its own campaign of printing money.

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The promise to keep short-term rates low for a longer period also caused longer-term rates to fall slightly, as seen in the 10-year Treasury rate chart below, which fell from about 2.05% to 1.95 %, a relatively modest decline.

What Does This Say about the Fed's Policy?

The most important action of the three was to extend the zero Fed funds rate to the end of 2014. This is a form of easing that could affect more rates than just short-term rates. Furthermore, there is a debate as to whether the action was the result of the Fed's concern about the economy slipping back into recession. Or, this could also be a bullish sign for the economy and stock market, as the guaranteed low rates could increase investment to improve our economy. Zero rates drive investors to take on risks – such as buying stocks – to gain higher returns. As a result, this induces more investment toward riskier parts of the market, which might otherwise be underfunded. Though the Fed aims to stimulate the economy, we're more likely to see a slip back into recession rather than see an effective Fed stimulus improving the economy.

The press conference suggested that quantitative easing (QE) remains on the table. As a result, new targeted asset purchases by the Fed are likely in our future. These additional purchases with newly printed money could become inflationary. That is why gold shot higher and the dollar weakened in the short term.

Both the Fed and the ECB have decidedly less-hawkish members and leadership than just last year. Both have now moved toward more money printing to keep rates low. The chart of central bank balance sheet as a ratio to GDP shows that the central banks of the world are clearly "printing":

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Longer-Term Implications

The problem with printing money and promising to do so for years ahead of time is that the negative consequences of inflation only happen after a delay. As a result, it's difficult to know if a policy has gone too far until years down the road at times. Unfortunately, if confidence in the dollar is lost, the consequences cannot be easily reversed. One problem for the Fed itself is that it holds long-term securities that will lose value if rates rise. The federal government faces an even more serious problem when interest rates rise, as higher rates on its debt mean greater interest payments to service. Due to this federal-government debt burden, the Fed has an incentive to keep rates low, even if the long-term result is higher inflation. However, for now the Fed's statement suggests it sees inflation as "subdued," so it's putting those concerns aside for now.

Along with the promise of low rates, the Fed for the first time gave an inflation target of 2%, as measured by Personal Consumption Expenditures. The actual and target inflation show that the Fed is currently not under major pressure from missing its target… not yet.

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The Fed has not even tried to set a target for the unemployment rate, which is only expected to edge below 8% by 2013. The Fed says that that the longer-run unemployment range is 5% to 6%. The big difference from the current level of 8.5% indicates that the Fed faces a greater challenge with unemployment than inflation now.

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My conclusion from the Fed's actions is that it doesn't care as much about its inflation target as it does about improving the unemployment rate. Thus, it will err on the side of letting inflation rise, if it would improve unemployment. But holding rates too low too long fueled the housing bubble. Repeating the same game will have consequences of malinvestment in the form of new bubbles in the economy. The Fed hopes to restore employment before the negative consequences of loose monetary policy show up.

The Fed provided the accompanying chart of the Fed funds rates expected by the seventeen members of the FOMC. Each dot indicates the value (rounded to the nearest quarter-percent) of an individual participant's judgment of the appropriate level of the target Federal funds rate at the end of the specified calendar year. Over the long run, the Fed expects the funds rate to rise to around 4.25%. Eleven of the members indicate that the rate will rise before 2015. Only six expect the rate to stay close to zero through 2014.

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The above chart should not be taken very seriously, as Fed predictions have been notoriously inaccurate. Furthermore, it's likely that rates will rise before 2014 as a result of market forces pushing them upward due to mistrust of the currency – measured by rising gold and commodity prices.

The Federal Reserve balance sheet expanded dramatically as the credit crisis became acute in 2008. The Policy Tools (shown below in black) grew by $2 trillion with the QE1 purchase of mortgage-backed securities and the QE2 purchase of long-term Treasuries. This was an unprecedented effort to support those markets, provide liquidity, and drive rates down to zero. A simple extrapolation of similar expansion policies to the end of 2014 suggests that the Fed may require an additional $2 trillion to extend its goals. The problem is that such action would surely weaken the dollar and drive gold much higher. If confidence is lost, rates could rise even as the Fed continues to print and buy securities. The Fed says that it will change its policy if conditions warrant. I think they will be forced to stop this policy well before 2014 is over. Nonetheless, in the meantime, they will plant the seeds of rising prices with ultralow rates.

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The gold price is driven by Fed policies and its bias toward printing money rather than defending the dollar's purchasing power. This Fed bias was again reconfirmed by this announcement. With all the Fed's renewed vigor toward keeping rates low longer, we can once again reconfirm the ongoing downward slide for the dollar. As a result, gold remains the best investment against the damaging government deficits and central bank policies around the world.

[While the dollar may look good compared to the other fiat contestants on the global money stage, the United States' debt situation is untenable – and various factors could bring it to its knees faster than anyone expects. Don't let it burn you: learn how to protect yourself and your assets.]

Don't Be Blind to Your Investments

By Vedran Vuk

In last night's Republican debate in Florida, Newt Gingrich went after Mitt Romney for owning shares of Fannie Mae, Freddie Mac, and Goldman Sachs. Romney pointed out that his investments for the past ten years were managed by a blind trust. Furthermore, the trust held mutual funds which in turn held those shares. As a result, Romney never handpicked those companies. In a nice jab back at Newt, he pointed out that Gingrich also owned those same companies through his mutual funds. Needless to say, that fact silenced Newt rather quickly.

Now, Mitt is partially right here. When buying a heavily diversified mutual fund, one is hardly choosing every single company in there. However, at the same time, one does own a small number of those shares through the mutual fund. Is it right or wrong? That's hard to say; it's definitely a morally gray area. It really depends on one's point of view.

At Casey Research, we often boast of our returns, but there are also non-pecuniary rewards to managing your own investments. You get to decide what's in your portfolio. It doesn't matter whether you're pro-life, an environmentalist, anti-bailouts, or anti-war, if you're holding a diversified mutual fund or ETF, I can almost guarantee that you're holding a company that would make you want to puke.  I'm serious… you might not want to look at all.

Unfortunately, diversified funds are the exact things our employers and financial advisers throw us into. Trust me, your financial advisor is not going to ask about your ethical qualms when offering fund options. But aren't there SRI (socially responsible investment) funds? Yes, but these have problems too. It can often be impossible to find a fund matching one's exact beliefs. Many of them overlap various beliefs together. Take for example, something like the Ave Maria Rising Dividend Fund (AVEDX), a fund supporting pro-life Catholic values. Sounds great for a pro-life supporter, right? Yes, but suppose that one is both pro-life and an environmentalist. In that case, the Ave Maria fund wouldn't work, as its top holding is ExxonMobil with a 4.1% allocation. The SRI funds can get one closer to an ideal portfolio, but it's still hard to find an exact match.

Now, many of readers might not care at all about this – and that's all right. But if you're the sort of person who can't sleep at night knowing that you own shares of BP, Lockheed Martin, or Goldman Sachs, then there's only one way to go. You'll just have to manage your money yourself, as it's almost impossible to avoid some morally troublesome company through a diversified mutual fund. If you're a hardcore environmentalist, perhaps our energy and mining publications are not the biggest help. For everyone else, we can help better guide your investment decisions. You can make great returns without owning the bailout bandits and other thugs in your portfolio.

Hockey Player Turns Down Presidential Visit

By Vedran Vuk

Here's an interesting story, oddly enough from the world of hockey. Tim Thomas, goalie for the Stanley Cup champion Boston Bruins, refused an invitation to the White House to meet President Obama with the rest of the team. What was his reason? Here's Thomas in his own words (all capitalization his):

I believe the Federal government has grown out of control, threatening the Rights, Liberties, and Property of the People.

This is being done at the Executive, Legislative, and Judicial level. This is in direct opposition to the Constitution and the Founding Fathers vision for the Federal government.

Because I believe this, today I exercised my right as a Free Citizen, and did not visit the White House. This was not about politics or party, as in my opinion both parties are responsible for the situation we are in as a country. This was about a choice I had to make as an INDIVIDUAL.

Those are some powerful words; I especially like his laying responsibility on both parties. As you can imagine, Tim Thomas is getting a lot of heat for his actions. How could he treat a US president with such irreverence? In my opinion, Thomas sent a message more important than his words – his absence brings the presidency down to Earth.

We currently have this strange relationship with politicians in our society. On one hand, practically everyone recognizes that politicians are the biggest liars and scum in these 50 states. Yet on the other hand, we're supposed to treat them like celebrities or god-kings. As they ruin our lives, enrich and empower their wealthy friends, and promise a worse future for our grandchildren, we're supposed to be overjoyed at an opportunity to shake their hands and smile for a photo opportunity. It's absolutely ridiculous.

Maybe my D.C. work experience has made me a bit jaded, but I just don't see anything special about meeting Congressmen, heads of state, and various Washington power players. They're all just people… most of them heavily flawed. They deserve no bowing down from regular citizens – especially from those who have been hurt by their policies.

Furthermore, the media don't look at things from Thomas' point of view. If Thomas doesn't support the president and doesn't personally like him either, then why should he partake in a smiling photo-op with the president? In our personal relationships, we certainly don't go out of our way to spend time and take pictures with people whom we dislike. I applaud Tim Thomas not just for his words, but for seeing beyond the glamour of Washington, D.C.

Friday Funnies

Here's a good one that's been going around for a few years. Supposedly, it's originally from the winning submissions from a Washington Post neologism contest, in which readers are asked to supply alternative meanings for common words. The winners are:

Coffee (n.), the person upon whom one coughs.

Flabbergasted (adj.), appalled over how much weight you have gained.

Abdicate (v.), to give up all hope of ever having a flat stomach.

Esplanade (v.), to attempt an explanation while drunk.

Willy-nilly (adj.), impotent.

Negligent (adj.), describes a condition in which you absentmindedly answer the door in your nightgown.

Lymph (v.), to walk with a lisp.

Gargoyle (n), olive-flavored mouthwash.

Flatulence (n.) emergency vehicle that picks you up after you are run over by a steamroller.

Balderdash (n.), a rapidly receding hairline.

Testicle (n.), a humorous question on an exam.

Rectitude (n.), the formal, dignified bearing adopted by proctologists.

Pokemon (n), a Rastafarian proctologist.

Frisbeetarianism (n.), (back by popular demand): The belief that, when you die, your soul flies up onto the roof and gets stuck there.

The Washington Post's Style Invitational also asked readers to take any word from the dictionary, alter it by adding, subtracting, or changing one letter, and supply a new definition. Here are this year's winners:

Bozone (n.): The substance surrounding stupid people that stops bright ideas from penetrating. The bozone layer, unfortunately, shows little sign of breaking down in the near future.

Foreploy (v): Any misrepresentation about yourself for the purpose of getting laid.

Cashtration (n.): The act of buying a house, which renders the subject financially impotent for an indefinite period.

Giraffiti (n): Vandalism spray-painted very, very high.

Sarchasm (n): The gulf between the author of sarcastic wit and the person who doesn't get it.

Inoculatte (v): To take coffee intravenously when you are running late.

Hipatitis (n): Terminal coolness.

Osteopornosis (n): A degenerate disease. (This one got extra credit.)

Karmageddon (n): it's like, when everybody is sending off all these really bad vibes, right? And then, like, the Earth explodes and it's like, a serious bummer.

Decafalon (n.): The grueling event of getting through the day consuming only things that are good for you.

Glibido (v): All talk and no action.

Dopeler effect (n): The tendency of stupid ideas to seem smarter when they come at you rapidly.

Arachnoleptic fit (n..): The frantic dance performed just after you've accidentally walked through a spider web.

Beelzebug (n.): Satan in the form of a mosquito that gets into your bedroom at three in the morning and cannot be cast out.

Caterpallor (n.): The color you turn after finding half a grub in the fruit you're eating.

And the pick of the literature:

Ignoranus (n): A person who's both stupid and an asshole.

That's it for today. David should be back next week. Thank you for reading and subscribing to Casey Daily Dispatch. I'll see you again the next time David is out.

Vedran Vuk
Casey Daily Dispatch Editor