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Wednesday, May 27, 2009

Boxed into Quantitative Easing

Since last I left off talking about the 10 year treasury, it has gone up another 35 basis points including 15 just today. Ever since the rumor last week that the U.S. debt might be downgraded, the bottom has fallen out of the Treasury. We have seen it go up from 3.15% last week to just over 3.7% today. Furthermore, over the next couple weeks we are going to several multi billion dollar new auctions as the government continues to borrow. Essentiall, over the last couple days, the market has come to realize that the federal government is going to borrow a whole lot of money and it's pricing that borrowing into the rate on the bonds.

Now, the projected recovery that some are claiming is near is in my opinion nothing more than a house of cards. It is built on several assumptions that will all relate to each other. The first assumption is that real estate is soon to bottom out, steady, and then recover. This means that the so called "toxic assets" on the books of the banks won't get any worse. It also means that we are about to peak on the number of foreclosures. This will lead to a recovery that will ultimately lead to new jobs.

The assumption that real estate will soon recover is all built on the assumption that interest rates will stay relatively low. So, what happens if rates, currently in the low 5's, go up to the low six's? That's the equivalent of something like a ten percent cut in the value of a property. That's because it would make a mortgage payment somewhere around $200 a month more expensive on a $200,000 loan amount for a 30 year loan. As borrowing costs go up, property value would go down. Credit is tight, the economy is weak, and no one has a job. The only thing attracting potential buyers to new purchases is the potential to lock in historical low interest rates. If that goes away, you are bound to continue to see the real estate market continue into free fall.

If that's the case, the domino effect on the house of cards on the so called recovery would fall as well. Now, I believe the president could relieve most of the pressure with one pronouncement. If he pronounced that universal health care was tabled until the economy recovered all the fears of borrowing too much would subside and interest rates would fall again to near record lows. That course, we all know this won't happen.

So, the only way to avoid the coming disaster is through "quantitative easing".

In practical terms, the central bank purchases financial assets, including treasuries and corporate bonds, from financial institutions (such as banks) using money it has created ex nihilo (out of nothing). This process is called open market operations. The creation of this new money is supposed to seed the increase in the overall money supply through deposit multiplication by encouraging lending by these institutions and reducing the cost of borrowing, thereby stimulating the economy.[1] However, there is a risk that banks will still refuse to lend despite the increase in their deposits, and in a worst case scenario, possibly lead to hyperinflation.[1]

Bonds rates are going up with reckless abandon and the government isn't going to stop borrowing with reckless abandon. Unless the feds get a handle on interest rates soon we are going to see whatever recovery we might have get stopped in its tracks. So, it appears that the Federal Reserve is boxed in. If bond rates continue upward, it appears that Bernanke will have no choice but to announce a major investment in U.S. Treasuries soon because that's the only way to bring interest rates back down to a level that would allow a recovery. Of course, the end of the link should tell everyone the potential disaster this could lead to. Still, it appears that in the next couple weeks Bernanke will have no choice but to engage in serious "quantitative easing" and buy back somewhere in the neighborhood of a trillion dollars worth of U.S. Treasuries.

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