Wednesday, March 18, 2009

FOMC to PRC, "Guess what, we don't need your money. We can print our own."


Once again we have had an interesting day in the markets. Today the Federal Reserve Open Market Committee announced that they would expand their purchases of mortgage backed securities and more importantly they announced that they would purchase long dated Treasuries outright. This is a very interesting development. The treasury achieves several things with this at one stroke. Firstly they lower longer dated interest rates which are important for mortgages. They do this by buying up treasuries which makes the interest rates go down on government securities. The US Government is generally considered the least risky investment you can make so by lowering rates on US government securities the Fed lowers rates on everything else. This should bring down corporate borrowing rates and indeed there was a rally in corporate bonds as well.

The government achieves a number of political objectives as well. The government is going to have to sell a lot of treasuries to pay for the stimulus package and the bank bailout packages as well as more normal funding needs. Very importantly they are doing it at a time when the total volume of world trade is falling off a cliff. Many countries with trade surpluses with America used to recycle their surpluses by buying US Treasuries with the dollar proceeds of their sales in the US. As the price of oil has declined along with world trade flows those surplus countries now have much smaller surpluses and therefore would not have been buying as many treasuries as they had been before. Now the Fed is coming out and telling people it is going to pick up the slack.

Now this is not free. There is going to be a cost to this. In big picture terms what is really happening here is that the Federal reserve is printing money and then lending it to the government which will then spend it on the stimulus package. We are effectively financing government expenditures with a printing press. It is likely that someday these chickens will come home to roost in the form of higher inflation. Some people disagree saying that asset price destruction is deflationary so some money printing is not a big deal. The markets don’t agree, which is why gold which began the day down about $20 ended the day up about $20. TIPS also had a good day.

Personally, I think it is interesting to look at this as a sort of conversation with China. Last week the premier of China publicly expressed concern about American treasury securities. To be frank this is an insult to the United States but one that China might rightly feel itself in a position to make. It is the largest non-US holder of Treasury securities. So why not tell your debtor what to do. It might be reasonable to think that given the massive levels of Chinese purchases of US treasuries if the Chinese went on a buying strike they might be able to single handedly raise US interest rates. This would make potential investors in US Treasuries nervous. This is why Hilary Clinton went to China right away and why the US government has been at pains to talk about reducing the deficit. That’s the nice guy approach.

Today the FOMC outlined the other approach. You could look at todays decision as a message to China: “We don’t need your money, we can print our own.” This is an interesting rebuke to China for two reasons. Firstly the US basically said today that the American central bank would print a sum about equal to 15% of Chinese dollar GDP and buy treasuries. Politically this is a rebuke but it is economically also a threat. America is basically telling China “If you do not buy treasuries with your surplus we will print money and buy them. If we do that we devalue the dollar, the currency in which most of your savings are held.” The fact that gold and oil spiked on this news is very important. Remember how the Chinese economy works. China is labor rich but resource poor. It has to import most of the raw materials that it uses to make things which it then sells abroad. Those raw materials are priced in dollars. As we devalue the dollar to make up for the bond purchases they are not making their margins are squeezed. So this could be read as economic brinkmanship with China and the stakes could not be higher.

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