Fed's $1 Trillion Debt-Buying Plan Loosens Lending and Drains the Dollar

By Jason Simpkins
Managing Editor
Money Morning

While the U.S. Federal Reserve’s plan to buy more than $1 trillion in debt has helped unfreeze the credit markets, it has also effectively capped U.S. Treasury yields and undermined the dollar. And that’s caused commodities to soar as currency speculators and safe-haven investors head for higher ground.

At the culmination of the policymaking Federal Open Market Committee’s (FOMC) two-day meeting Wednesday, Fed Chairman Ben S. Bernanke revealed that the central bank would purchase up to $300 billion in longer-term Treasury securities, as well as an additional $750 billion of mortgage-backed securities. The central bank also said it would buy debt issued by government-sponsored agencies such as Fannie Mae (FNM) Freddie Mac (FRE).

“To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion, to a total of up to $200 billion,” the Fed said in its statement.

“Moreover,” the statement went on, “to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.”

Many analysts believe that Bernanke’s announcement was a bold attempt to instill confidence in the markets and loosen credit for consumers and businesses.

Harm Bandholz, economist at UniCredit Research in New York, noted that the Fed had bought only 19% of the mortgage-backed securities and only 40% of the agency debt that it had already said it was buying, so there was no rush to announce more purchases.

“The Fed employed its shock-and-awe policy,” Richard Schlanger, a vice president at Pioneer Investment Management – who helps invest $13 billion in fixed-income securities – told Bloomberg News. “This has to have a profound impact on credit spreads going forward.”

However, others like BBC economics editor Stephanie Flanders said the only shock from the Fed’s decision was felt by investors who view the act as more desperate than bold.

"Why have this new spending spree at all?" she asked. "The answer may be that the Fed – and the administration more generally – is concerned that the apparent improvement in credit conditions the past few months is a false dawn."

The Conference Board’s gauge of lagging indicators, which measures business lending, length of unemployment, service prices and ratios of labor costs, inventories and consumer credit, dropped 0.4% last month – after posting a 0.3% drop in January.

The London Interbank Offered Rate (LIBOR), the overnight rate at which banks charge each other for loans, stood at 1.33% last Wednesday – a week before the Fed’s announcement. That was near the highest level since Jan. 8 and up from this year’s low of 1.08% on Jan. 14, the British Bankers’ Association said. The rate stood at 1.29% Tuesday. The rate dropped about six basis points yesterday (Thursday) to 1.23% – its lowest level in two months. The LIBOR-OIS spread, a gauge of bank reluctance to lend, slid seven basis points to 100 basis points, Bloomberg reported.

Commodities Soar as Treasuries and the Dollar Lose Their Allure

Chairman Bernanke’s ambitious asset purchase plan may have unlocked the credit markets – at least for the time being – but it also capped Treasury yields, driving investors from the currency many had fled to as a safe haven.

The yields on 10-year Treasury notes fell 47 basis points – the most since 1962 – after the Fed’s announcement Wednesday. The yield on the notes, which climbed as high as 3.02% Wednesday, stumbled back down below 2.5%.

“The Fed is capping Treasury yields,” David Glocke, who manages $65 billion of Treasuries at Vanguard Group Inc., told Bloomberg. “I don’t think we will see rates drift back up above 3%; everyone looks at that as being the ceiling.”

Glocke added: “If rates drifted to that level I’d be a buyer.”

At this point, Bernanke is basically financing the national deficit by buying debt issued by the Treasury. In addition to capping Treasury yields, expanding the Fed’s balance sheet and printing more money to accommodate these purchases has sharply undermined the value of the dollar.

“This definitely introduces a longer-term current of downside pressure on the greenback,” Sacha Tihanyi, a Toronto- based currency strategist at Scotia Capital Inc., wrote in a note to clients. “The Fed pulls out all the stops and the U.S. dollar gets whacked. The market will be looking to find its feet over the next few sessions.”

The euro traded as high as $1.3716 yesterday (Thursday), the highest level since early January, according to Reuters data.

"Apart from being negative for the dollar, we expect yesterday's events to be bullish for commodity currencies such as the Australian dollar, Norwegian crown and Canadian dollar, and currencies of countries less likely, for whatever reasons, to engage in the monetization of government debt such as the euro," Barclays Capital (BCS) strategists said in a research note.

The Norwegian crown gained as much as 3.2% yesterday, while the Australian dollar touched 69.44 U.S. cents, the highest since Jan. 12, Bloomberg reported. And the Canadian dollar touched C$1.2193 per dollar, its strongest level since Feb. 10. The Canadian currency has climbed 2.8% in the last two sessions, the biggest two-day rally in three months.

Both gold and oil soared more than 7% yesterday, with gold for April delivery surging $69.70, or 7.8%, to end at $958.80 an ounce on the Comex division of the New York Mercantile Exchange. Oil briefly topped $52 a barrel before settling the day at $51.72 a barrel on the NYMEX.

By allowing the dollar to weaken, Bernanke is basically betting inflation will not return in force for sometime. Analysts are split on the tactic.

Some analysts believe the central bank has little choice but to put concerns about inflation aside for now and focus on sparing the economy a far worse collapse. But others, like Michael Farr, president of Farr, Miller & Washington LLC, are far more skeptical.

"Looking ahead, we fear inflation,” Farr told MarketWatch. “It may be that Dr. Bernankenstein has created a monster beyond his control.”

News and Related Story Links:

• Federal Reserve:
   Press Release

• BusinessWeek:
  The Fed Breaks Out the Heavy Artillery

• BBC:
  Dollar slides after US Fed plan

• Bloomberg:
  Three-Month Dollar Libor Falls by Most in Two Months, BBA Says

• Bloomberg:
  Canada’s Dollar Gains on Inflation Data, Higher Risk Appetite

• Reuters:
  Dollar struggles to recover after Fed opens taps

• Money Morning:
  Inflation Gently Rises in February, Offering Analysts a Sign the Economy Isn’t Collapsing