Is the Fed Turning the Dollar Into Monopoly Money?

by Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research
April 14, 2009

What is the Federal Reserve doing?
When the Fed announced it will purchase "longer-term" U.S. Treasury securities in addition to mortgage-backed securities (MBS), it demonstrated that it will do whatever it takes to restore normalcy to credit markets.

In addition to other actions the Fed is undertaking, the Fed, in effect, has cranked up the printing press for U.S. dollars to overdrive. This action could conjure visions of hyperinflation, during which the currency becomes so abundant that its worth falls rapidly, and inflation rises.

By purchasing Treasuries, which form the basis for setting lending rates in many different credit markets, the Fed is trying to make borrowing more affordable for everything, including loans on cars, mortgages, corporate bonds and lower rates on credit cards.

However, there are consequences of such a program and, as we'll see, there's no such thing as a free lunch.

Why is the Fed doing it?
To tackle the credit crisis and stimulate growth, the Fed has expanded beyond mortgage purchases. As the fed funds target is near 0%, the Fed cannot lower rates further by using its traditional rate cut mechanism.

As such, the Fed's had to get creative: It has pursued new programs to revive the economy, and initially announced it would purchase MBS in an attempt to lower mortgage rates back in November 2008.

Mortgage rates are largely priced based on three factors:

10-year Treasuries.
Fannie Mae and Freddie Mac (agency) bonds.
A spread that includes costs to underwrite and service mortgages.

The impact of the Fed's MBS purchase program has lowered agency rates, however, the spread (the difference between what homeowners pay and the agency rate) has remained elevated, as mortgage originators remain reluctant to lend.

Spread remains elevated

Chart: Spread remains elevated

Sources: FactSet, Freddie Mac and the Fed. As of April 3, 2009. *Equals 30-year mortgage rates less 10-year Treasury yield. Basis points.

The Fed seeks to push rates down further to give homeowners the ability to lower their house payments and to try to stimulate the housing market by making housing more affordable. By expanding its arsenal of tools to stimulate credit markets and purchasing Treasuries, the Fed can theoretically lower rates for many different markets, including mortgages.

The Fed is simply bypassing the banks, which are concerned about their capital ratios that deteriorate with continued falling valuations in their underlying collateral, such as home loans. As a result, banks have been continually writing down assets, increasing their need for future capital.

Consequently, banks have been hoarding cash and have been reluctant to lend, making loans more restrictive to get by making it harder to qualify for the loans and offering loans at elevated spreads.

What are the risks to this action?
There are four main implications of Treasury purchases:

Compels investors to invest in riskier asset classes.
Lowers the value of the dollar and raises the potential for future inflation.
Subsidizes increased government spending and stimulus.
Obscures the risk premium calculation.

The first implication is that Treasury yields can become so low that investors start to purchase riskier assets. Long term, this is a good thing. There is a "crowding out" effect of lowering Treasury rates, as the implied return on the securities becomes so low that investors seek to deploy their capital elsewhere.

As 2008 came to a close, the 10-year Treasury yielded less than 2.1%, a record low.

In January 2009, investors shifted to more risk-seeking investments, as the rates on Treasuries were less attractive relative to the high rates afforded on other investment alternatives.

For example, below-investment grade bonds were yielding 20% in late 2008 and investment-grade yields were 9.3%, the highest in 17 years.

As investors took the first step out on the risk spectrum to the corporate bond market, large corporations with investment-grade ratings were able to find investors who were interested in purchasing their debt: Nonfinancial debt issuance tripled in the first quarter of 2009 versus the first quarter of 2008.

The Fed printing press has the potential to stoke inflation, but the near-term risk is deflation. By increasing the money supply through massive purchases of debt, the Fed expands its balance sheet and "prints money."

With more money chasing goods, this can stoke inflation. However, deflation, a period of lower prices, is a risk in a slowing economy with extra slack and falling consumer spending.

The goal of the Fed is to achieve a modest rate of inflation, as a low level of inflation provides the basis for a stable economy. Inflation is partly a sentiment factor, as an environment of rising prices compels consumers to spend now, before prices rise in the future.

The mirror of this is a deflationary environment in which consumers hold off on purchases now, in the hopes of lower prices in the future, which further pressures demand.

Debt deflation is particularly troublesome, as an environment of falling prices causes assets to fall in value, yet debt values don't fall in concert. As a result, the net worth of borrowers becomes overwhelmingly negative. Deflation is the near-term risk, but longer term, the Fed will need to unwind its positions carefully.

Inflation will not occur until the money multiplier expands, as a result of increasing supply of and demand for lending. Learn more in Liz Ann Sonders' related article, Deflation Is Today's Threat, not Inflation.

How does this affect the U.S. dollar? While Treasury purchases would force rates lower, it would also discourage foreigners from purchasing Treasuries, as they would look elsewhere for higher yields, effectively lowering demand and valuation of the U.S. dollar.

A modest weakening of the dollar might be positive, as it would make U.S. goods less expensive to foreign buyers and therefore more attractive overseas. The Fed's initial announcement hit the dollar sharply, and the greenback posted its biggest daily fall against a basket of currencies in more than two decades.

However, if the U.S. dollar entered into an extended downward trend, this would be a significant negative unintended consequence, as it would create import inflation and would impair the ability of the U.S. to issue debt at reasonable rates in the future.

Does this impact the government's issuance of debt to support spending? Concerns swirl that the United States is about to engage in a massive issuance of debt to fund stimulus measures and a growing federal deficit. The issuance of large amounts of debt would require large price discounts to attract buyers, which would force Treasury rates higher.

A benefit of the Fed buying Treasuries is that it effectively reduces the interest rate at which the Treasury issues debt to finance America's ever-growing deficit. While the Fed is indirectly funding the government's spending, that is not the goal.

The Fed is attempting to restore normalcy to private credit markets and, while credit markets have improved from the paralysis following last year's Lehman Brothers fallout, rates remain elevated.

Yields remain high

Chart: Yields remain high

Sources: FactSet, Moody's and the Fed. As of April 7, 2009.

How do the Fed's actions affect measurement of the risk premium? Investors look at the spread (difference) between what Treasuries and corporate bonds yield to determine the level of risk that is being priced into a bond—the higher the perceived risk, the higher the spread.

Fed purchases make risk premiums harder to gauge, and make it more difficult for investors to determine whether credit markets are returning to normalcy. This is a consequence of creating false demand for Treasuries.

How will we know whether it's working?
Banks are facing pressures from several areas: deteriorating credit, capital constraints, and increased regulation. In response, they have made lending standards more restrictive and have kept spreads high in order to make profits where they can get them.

We will be watching credit spreads, bank cash assets, and amounts of loans made to measure whether the Fed's program is meeting its stated intentions.

What are the implications for investors?
While inflation is not a risk in the short term, the current low level of interest rates and the longer-term risk of higher rates suggests that, for homeowners who plan on staying in their homes, it might be a good time to refinance mortgages that are currently priced at higher rates.

Additionally, TIPS (Treasury Inflation-Protected Securities) are a way to buy protection from longer-term inflation concerns. TIPS are currently priced to anticipate just under 1% annual inflation during the next 10 years, which is low compared to historical averages. For more on our bond sector views, see Liz Ann Sonders' and Brad Sorensen's Schwab Market Perspective.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.

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