Saturday, February 7, 2009

A Fed Paradox?

A couple of months ago, the Federal Reserve pre-announced possible intent to purchase long-dated US treasuries. I chalked this up as a follow-through to their zero-interest-rate policy because it was accompanied with a verbal commitment to maintain the ZIRP policy for a considerable time into the future. The hoped-for effect was to hammer down the far end of the treasury yield curve.

I had chalked it up to a clever statement designed to get others to do the deed, because the mere announcement sent investors scrambling to buy treasuries ahead of the Fed, looking to capitalize on on the demand for treasuries later when the Fed began buying. This had the perverse effect of making the Fed purchases unnecessary, since long-dated treasuries were now being purchased in large quantities.

Then the Fed reiterated the commitment, but think about this possibility: the sheer amount of debt the Treasury must issue is going to send yields up. All these investors who wanted to jump the Fed's purchase program might start dumping their treasuries, causing yields to go up further as the Treasury now has to compete with the glut coming to market.

So now we would have treasuries tanking, and the Fed would do what? Would it start buying en-mass? Would this get others buying treasuries? I think not! I think the Fed could find itself buying more and more treasuries only to let others bail on them while the bailing is marginally good.

The Treasury would be financing US debt by greatly expanding the Fed balance sheet. Who's going to jump on that train? I would think this would lower the demand for treasuries because it is inflationary.

Is there a scenario where we don't end in severe to hyper-inflation? What would be the effect of just defaulting right now?

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