Daily Equity Report

Yesterday the Federal Reserve announced that it would step up its program of increasing US monetary base by buying $300 billion of treasuries over the next 6 months and increase its program of buying mortgage backed securities by $850billion. This will expand the US Federal Reserve’s balance sheet by over $1 trillion, taking it up to over $3 trillion.

The headline say “Dollar rally crumbles as Fed ramps up Printing Press”

The aim of the US Fed is to lower borrowing costs, increase liquidity, allow mortgages to be issued to homeowners and ultimately slow the price decline of houses and other assets.

But there are many questions, as to how this process works : Some questions you may be asking:

How exactly does this work in the US. If the government can print money, why does it also need to issue bonds, i.e. issue debt instruments on which it has to perpetually pay interest. The debt exposure has climbed and climbed and is now around $11 trillion – heading back to the equivalent of the US GDP.

If the government is “printing” so much new money, then why did the interest rate at which investors are lending the US money – i.e. the yield – drop so sharply from just over 3% to around 2,47% yesterday.

With such a massive contraction in global wealth, just who is going to fund the US government’s obsession to plug all the holes in the banking system.

Let’s look at a few answers from Ellen Brown who wrote a book titled, Web of Debt and who has a very good understanding of the mechanics.

One needs to understand that the US Federal Reserve is a quasi government organisation, created in 1913. It acts as lender of last resort and this is what we are seeing now. It comprises 12 regional privately owned Federal Reserve Banks. These include the New York Fed, which are not federal agencies.

The Federal Reserve has the ability to create money.

According to Brown, “The Fed originates the money it lends, either on a printing press or with accounting entries. It can purchase Treasury debt simply by writing credits into the “reserve account” of the seller’s bank, which then credits the seller’s account. The Fed’s ability to write numbers into an account is obviously unlimited; but it has normally restricted its purchase of government securities to only so much as is necessary to provide the liquidity needed for banks to cash and clear checks. Funding the government’s budget shortfall has usually been left to private lenders; but those loans are drying up, and servicing them is proving expensive.”

Now this is exactly what they are starting to do – print and buy newly issued debt issued by the US Treasury, which IS the US government. The government sits with the ballooning debt – which needs to be serviced with interest, while the “private” Federal Reserve inflates its assets – see graph.

The gnawing question is why does the government – which supposedly has the ability to create money – have to actually issue debt. Why don’t they merely print money and spend it buying banks, spending on construction etc – whatever they think is necessary to bolster the economy.

This is largely Brown’s main argument. She says, “When you understand this sleight of hand, the way out of the government’s debt trap appears equally simple: Congress could just nationalize the Federal Reserve and print Federal Reserve Notes itself. This government-issued money could then be either spent or lent into the economy to get the wheels of production rolling again.”

Bernanke originally announced the idea of buying Treasuries in December, but in papers even a few years back he mentioned this possibility.

The Bank of England announced similar moves as did the Swiss National Bank.

Longer term, with the supply of bonds on the rise as government’s expand and encroach on economies, its very difficult to see how yields on long term debt can stay at low levels. For the time being however this is the bull market.

10 Year Treasury Note

Clearly a correct assessment of the long term bigger picture was very beneficial. Lower and lower interest rates from a peak in early 1980’s drove up returns on bonds and also real assets.

Now with interest rates at record low levels and governments having to step up borrowings, lenders are not being rewarded for the risk of a devaluing currency.

Strategic and tactical asset allocation becomes hugely important for all investors. If you have not had a thorough assessment of your asset allocation and the longer term implications, then don’t hesitate to contact us. Mail Vincent on Vincent@seedinvestments.co.za

Kind regards

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966