By starting another asset purchase program, the Federal Reserve delivered on its promise to do more for the economy. The asset du jour, as expected, is Agency Mortgage-Backed Securities. In a surprise move, though, the size and duration of such purchases is not predetermined, but is, rather, open-ended. The Fed expects its balance sheet to increase by $85 billion per month indefinitely.
The markets reacted as you would expect them to: Euphorically.
Days like yesterday are phenomenal days for anyone with any interest in monetary policy making. You learn more from them than in any course in advanced macro in a graduate school.
So what did I learn yesterday?
First and foremost: In a fiat currency regime, the Fed is the omnipresent and omnipotent Supreme Being. It can basically do anything to make the market bend to its will. You can accept it without a word or by kicking and screaming but at the end of the day, its view will rule. The Fed may not change the course of the economy, but it can certainly make your life miserable if you stand in its way.
Second, the Fed is committed to doing something and everything. The open-ended nature of the commitment makes it quite clear: the Fed is going to be on the case for as long as it takes (or until they are kicked out by the politicians in due time). But for now or any reasonable investment horizon, a very aggressive and proactive Fed is something that we have to incorporate in our scenario analysis. The Fed is telling you to believe in its commitment and, after yesterday, we have no choice but to do that.
Third, never say that the market is discounting something fully. We had been thinking that tight spreads in mortgages were discounting most of the potential good news out of the Fed. Then current coupon mortgages rose by a point yesterday. That is equivalent to the S&P 500 Index rising 5% in one day. Unbelievable! The Fed is going to be taking out virtually all of the new supply of mortgages—and then some.
Fourth, I believe yields on funds benchmarked to the Barclays Aggregate Bond Index are going to drop precipitously over the next few months as mortgage-backed securities rally. This is despite the fact that Treasury rates will likely back up as investors take on more risk. With Treasuries already seemingly priced to perfection and mortgages heading there, what’s next for investors? The hunt for yield globally will continue for the foreseeable future. We continue to favor credit.
Fifth, the virtually simultaneous commitment by the world’s two largest central banks to purchase unlimited assets (see my previous blog post on the European Central Bank’s steps to ease pressure on Europe’s troubled secondary sovereign bond markets) is not only unprecedented and historic, it’s game-changing. At some point, the cracks and fissures in the Chinese economy will steal the show, but for now it’s risk on for the foreseeable future.