Fed Nearly Goes All In

I like most got the Fed wrong today. Last week I took heat for alluding to the risk of Fed announcing it would start buying Treasuries today based on the Hilsenrath article in the WSJ. So what did I do? I put the car in reverse and joined the crowd - for all the "right" reasons. Dudley met with the buy side and said just weeks ago it was not a good idea. And we learned after the January meeting that the Fed had cooled to the idea. And since when does the Fed follow the BOE on one week's success of Gilt buying.

Okay off with the myopic ticker glasses and at 30,000 feet (at 3,000 feet) these are no ordinary times. The message the Fed delivered today is that things are still horrific. And anyone listening to Liddy of AIG testify in Congress, he and the Fed (implied) agreed that not paying the retention bonuses to AIG FP could bring down the firm and the financial system (eye opener that this firm is still that vulnerable). These are extraordinary times and require extraordinary policy. And don't lose sight of how badly markets have failed and how much of a role there is for the government to support capital and aggregate demand.

So why is it nearly all in? Because a $3trln balance sheet at the Fed is still small relative to the total economy, distressed assets, semi-distressed assets and the scale of the problem. I would think that before we are at the other side of this crisis the Fed's balance sheet will approach $10trln. North of $5trln today would have been all in for me. Don't get me wrong this is very big. And very helpful. I am now going to refinance.

The dollar is the shock absorber to this move - or better by-product. Yields across the curve are now less attractive relative to the rest of the world and the dollar will suffer. But a $3trln balance sheet at the Fed is not hyperinflation or the basis for a run on the dollar. If anything the UK proportionately is in deeper from a policy response than the Fed and cable is above where it was before the BOE announced it would start QE and buy Gilts. And I think the UK economy is far more vulnerable to deflation than the US economy - concentrated in finance and housing and diminished natural resources (North Sea oil).

Moreover, the pressure on the ECB is building to follow the lead of its cohort c banks to QE or face an appreciating euro. Too bad JC Trichet and his inflation apostles are going to have a religious conversion drilled into them by a rising euro for an export-led (German-led) economy. I think you have to think a bout selling euros above 1.35 and surely with stops to sell higher through 1.40 (staged). This could turn into a damned if they do and damned if they don't for the euro (lower on both fronts as proactive US policy supports the dollar in FIFO scenario).

Lastly, I would say anyone talking about a ZWD outcome for the USD should be flogged (verbally). There may be a time when the markets sell the exit strategy and the USD from reflation, but first we have to see the death of deflation and it is here, it is everywhere.

I would be remiss if I did not address the poor handling of the message by the Fed - walking people out on buying Treasuries in December, walking them back in January and then walking them out and back and out again in the last week (post BOE QE Mar05). The Bernanke Fed has been cursed on the message front from the get go - remember Bernanke spoke to CNBC's Bartiromo in what he thought was off the record in his first few weeks on the job only to learn it was on the record. For those who trade on the inside noise the answer is stop. Never say never rule is in full force and the times are so extraordinary that the officials do not know what they will do next.

At risk of sounding contradictory, Bloomberg today reported that Fed and Treasury officials are considering using TALF to buy bad assets from the banks. Clearly this is not the intended purpose of TALF (not really structured for this). In today's FOMC statement all the Fed said about TALF, due to start Thursday with a Nissan issued ABS (can hear the shrill from Washington already), was it may expand the type of collateral it will accept for those who participate in the program (makes me think of Aitken's quality collateral constraint worry).

David Gilmore

Foreign Exchange Analytics
http://www.fxa.com

Disclaimer: The opinions expressed herein are those of the author and not a recommendation to buy or sell specific securities.