Last week, the Federal Reserve announced it would begin buying “the long end of the yield curve”. What does this mean exactly?

On March 18, the Federal Reserve announced it would spend up to $1 trillion to buy treasury notes and mortgage securities. (Source: Bloomberg, March 19, 2009)

According to an article published yesterday on Bloomberg, the Federal Reserve will focus on buying US Treasuries with maturities of 2 to 10 years and spend up to $300 billion to do so over the next 6 months. In addition, the same article suggests the fed will also increase its buying of mortgage backed bonds issued by government backed entities like Fannie Mae and Freddie Mac from the current commitment of $500 billion (made last fall) to as much as $1.25 trillion.

This move by the fed last week sparked the largest drop in Treasury yields since 1962. (Source: Bloomberg March 19, 2009) This means the selling price of Treasuries went up since bond yields and prices move inversely.

Where is the Federal Reserve getting this money?

It’s simply printing it. The fed wants to keep bond prices high and interest rates low in an attempt to revive lending, so it has now becoming the buyer for these securities.

Short term, the stock markets reacted positively, which was not surprising, but at the same time as the stock markets were rallying, so was gold and so were other currencies that go against the dollar.

It was a bold move for the fed. With the fed funds target interest rate at 0% – .25%, the fed couldn’t reduce interest rates further in order to try to get more money flowing into the economy. So in an unprecedented move, the fed elected to buy back government debt with freshly printed money.

If you’re a poker player, this move by the fed might be described as going ‘all in’. When the fed is buying government debt and replacing it with even more debt, the end result is something known as monetizing the money supply, or, as the fed prefers to call it, ‘quantitative easing’. Simply put, the fed is creating US Dollars almost from thin air.

The result?

As noted above, the US Dollar fell and gold prices rose.

China, however, didn’t view the move by the fed as positively as the equity markets did. In an article published on Fox News (March 24, 2009), China’s central bank governor called for the creation of a new currency to replace the US Dollar as the world reserve currency. The suggestion was part of a sweeping proposal to overhaul global finances and reflects how unhappy China and other developing nations are with the US’s role in the global economy.

Russia agrees with China. Earlier this month, while preparing for the G20 meeting, Russia went on record recommending that the International Monetary Fund issue the new world reserve currency, and noted the need to “update the obsolescent uni-polar world economic order”.

More freshly printed dollars will likely devalue the dollars already in existence, a problem for any nation who holds US dollars in reserves. However, for the US Government, with no real reserves, devaluing the dollar allows for repayment of debt with dollars that are worth less than the dollars under which the debt was accumulated. The end result (in my opinion) is a “worldwide poker game” with billion, even trillion dollar stakes.

How might this affect US citizens?

If the feds recent action creates the liquidity it wants, it’s my view that inflation, perhaps even hyper inflation could potentially soon follow. If this happens, those at the lower end of the economic scale may likely be affected, spending a greater percentage of their incomes just for necessities and reducing the dollars available for discretionary spending, creating another potential drag on the economy.

If you have accumulated wealth, it’s my view that you need to look at dollar alternative investments and absolute returns* investment strategies.

Securities offered through Empire Securities (Member FINRA/SIPC). Advisory services offered through Empire Securities. The opinions expressed herein are those of the writer and not necessarily that of the above noted affiliated companies. This update may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted.

* Absolute return investment strategies aim to produce a positive return regardless of the directions of the financial markets by investing in cash or other low volatility investments and then taking hedged long and/or short positions in securities that when combined are expected to have modest exposures to market returns. No investment strategy is 100% accurate. Investing in market related securities involves a risk of principal loss. Prior to making any investment decision, the services of an appropriate professional should be sought as investment related recommendations are dependent upon the personal financial situation of each individual investor.

I want to tell you a story about an average American whose name is Fred*. Fred is an older guy, approaching retirement, who has spent his entire life working on his family farm in Nebraska.

He’s accumulated some wealth, although by the standards of the mega-wealthy it’s really a pittance, but he’s worked hard, lived frugally, and managed to accumulate some money. On top of that, Fred has been a smart, albeit conservative with the way he’s managed his personal finances, never borrowing a penny after he’d paid down all his debts at a surprisingly young age.

Fred, like “The Millionaire Next Door” described in the blockbuster book by the same name, drives an older automobile for which he paid cash, and even though he could easily afford a new car of almost any make and model, Fred doesn’t see the need to spend the money since his old car is running just fine. And, Fred kind of likes his 1997 Cadillac Deville. Even though it’s got 120,000 miles, it runs just fine and it was the first ‘luxury car’ Fred ever bought, even though he bought it used in 2002 at a really good price. Besides if he traded the car in on a new model, he’d only get $2,500 on a trade, and assuming he could be lucky enough to sell the vehicle outright to a private buyer, he might get $3,500. Fred, having a lot of common sense, figures he might as well keep the old car and drive it.

Then one day, Fred discovers to his dismay, that the old Cadillac needs major repairs. After getting estimates, he discovers the engine and transmission repairs are going to cost him almost $4,500; so, having some common sense, Fred decides it doesn’t make any sense to put $4,500 into a $2,500 car – so he sells the old Cadillac to a local used auto parts supplier for $1,000 and buys a different car.

Makes sense right?

Good thing Fred isn’t a congressman or a Washington Bureaucrat. If he was, he’d not only spend the $4,500 to make the repairs to the $2,500 car; while he was at it, he’d get new leather seats installed at a cost of $4,000, get a paint job added for another $4,000, and put new tires on the car at a cost of another $1,000. Congress would not only repair something that didn’t make financial sense to repair, they’d make unnecessary repairs as well.

Too bad no one in Washington summoned Fred and asked for his advice prior to the current financial industry bailout. Fred would have likely made far different choices.

To date, the AIG bailout has cost taxpayers $182.5 billion (Source: Bloomberg, March 23, 2009). As of last week, the total market capitalization of AIG was about $3.7 billion. If you’re not familiar with market capitalization, it’s calculated as the total shares of stock outstanding times the current share value. AIG has approximately 2.7 billion of shares outstanding at a share price of about $1.40 which means you could buy the company for $3.7 billion, yet the government has invested over $180 billion for their 80% stake.

So, the government has ‘invested’ $182.5 billion in a company that’s currently worth $3.7 billion and they don’t even own it 100%. Even giving the government the benefit of the doubt, if we look at the market capitalization of AIG on October 1, 2008 when AIG was trading at $3.95 per share, the market capitalization of the company was $6.65 billion, yet the government committed to giving AIG far more money than the company was worth.

Where was Fred when we needed him?

If you’re not in the mood for a rant, skip this entry.
They say that there are two powerful emotions responsible for most of human behavior – greed and fear – with fear being the more powerful of the two.
Politicians know this and, as the House Speaker, Nancy Pelosi is no stranger to playing the fear [...]