Is the Fed’s Treasury ‘Work’ Done?
By Ron DeLegge, Editor
July 13, 2011
The good news is the Federal Reserve stands ready to help if the U.S. economy acts worse than expected. The bad news is the U.S. economy needs help.
Thus far, the Fed’s monetary trickery has helped to inflate U.S. stocks (NYSEArca: VTI) and U.S. Treasuries (NYSEArca: TLT) but not much else. Ben Bernanke, the Fed’s Chairman, actually went on record to say his private organization's bond buying program could boost U.S. employment by about 700,000 over the next two years. Is he serious?! If creating jobs by purchasing bonds is such a great panacea, why haven’t the 7.2 million pre-recession jobs suddenly returned?
If we were to choose a theme song for the Federal Reserve, the 1977 hit song “Three Little Birds” by Bob Marley would be it. The lyrics are immensely reassuring not to mention repetitive. The song’s main chorus says, “Don’t worry ‘bout a thing ‘cause every little thing gonna be alright.” Unfortunately, “everything is not alright.”
U.S. Government’s AAA-Rating
Bernanke's latest "work" has been to warn Congress to raise the nation’s debt limit and if not, then to expect another financial crisis. Although it has not yet officially defaulted, the U.S. government is in a fiscally dire situation. Even if lawmakers temporarily raise the debt limit, it still doesn’t eliminate the debt. Furthermore, any unexpected uptick in interest rates would increase the government’s borrowing cost and make debt repayments much harder.
Despite the reality of the situation, major credit rating agencies maintain their AAA-rating of U.S. government debt. Why have they done this? I think it’s mainly because the nightmare of mis-rated AAA-rated mortgage debt that was ultimately proved worthless is a distant memory. Likewise the “warnings” from these agencies about a potential credit U.S. downgrade are comparable to the boy that cried wolf. After so many false alarms, people wised up and stopped listening.
Years ago Warren Buffett warned that, “Debt is a four-letter word” but apparently, Fitch Ratings, Moody’s (NYSE: MCO) and Standard & Poor’s (NYSE: MHP) never got the memo. Normally, corporations and individuals faced with a debt crisis like the U.S. government’s have their credit lines and credit rating immediately yanked. Are credit agencies applying a double standard when it comes to government rated debt? And if so, why isn’t the Securities and Exchange Commission doing anything about it?
For the rest of us, it should raise red flags everywhere and anyone making investment decisions based upon the false-comfort of pristine credit ratings better re-think their strategy. Or as a bond analyst once told me: “Credit ratings are assigned after analysts carefully analyze old financial statements.”
Since late last year, the Federal Reserve has been the largest buyer of U.S. Treasury debt (Nasdaq: FGOVX). But its QE2 program which gobbled up $600 billion in U.S. Treasuries ends on June 30th. This has caused some observers, like PIMCO’s Bill Gross (Nasdaq: PTTRX), to speculate that Treasury prices (NYSEArca: IEF) will fall sharply without the Fed’s continued supportive buying. Is the appetite for U.S. Treasuries by foreign buyers and other market players enough to overcome the Fed’s exit? On paper, the logical answer is “no.” However, if a pending collapse in Treasury prices is the consensus view, as it seems to be, it probably won’t happen.
For sure, the Fed’s the artificial involvement in the U.S. Treasury market remains intact. Regardless of whether they stop buying, the majority of their $3 trillion balance sheet is stuffed with U.S. paper. And furthermore, they could very well continue future purchases, as they’ve already alluded to.
Confluence of Factors
We know the Fed’s “work” at propping up the Treasury market and keeping interest rates low isn’t done. Regardless, forces larger than the Federal Reserve are taking shape.
Although the public’s attention is fixed on Congress and its August 2 deadline, a confluence of other factors will drive the future price of stocks, bonds and interest rates. What are the odds of a default? ETFguide’s ETF weekly pick on U.S. Treasuries outlined the likelihood of a default by the U.S. government along with specific ETF strategies.
Beyond the Fed’s tinkering, investors should expect the unexpected. Why? Because this time is different.