Fed's Spring Tightening Won't Stop Price Hikes
The Federal Reserve's free money policy is coming under even greater scrutiny following release of the November Non-Farm Payroll Report and latest Bureau of Labor Statistics inflation data. The spate of "less bad" news on the economy, and increases in certain price levels, has brought some bond vigilantes out of hibernation. Meanwhile the cacophony from hard-money guys - me chief among them - is now calling on the Fed to raise interest rates sooner rather than later.

Unfortunately, I expect the Fed to watch the economy from the bench through nearly all of 2010. The reason is simple: The central bank has already scheduled a tremendous de facto
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monetary tightening. It will occur at the end of the first quarter. That's because the Fed's purchases of $1.25 trillion in Mortgage Backed Securities (MBS) are scheduled to end in March. (For background reading, see The Risks Of Mortgage Backed Securities.)

Why that represents such a dramatic tightening is that Fed Chairman Ben Bernanke has been buying up 90% of all newly created pooled mortgages, according to the St. Louis Federal Reserve. Such mortgage backed securities (MBS) are instruments created by Fannie Mae and Freddie Mac and then sold to the Fed. For all intents and purpose, in other words, the Fed is the securitization market for mortgages.
Securitization has become essential to bank lending. With banks lending at fixed rates and borrowing at floating rates, their ability to sell the loans they originate removes them from the institutions' books and thus insulates them from interest rate fluctuations. If the securitization market dries up, and financial institutions have a hard time selling off their loans, mortgage interest rates will rise while the volume of mortgages issued falls.

So far fixed-income investors' appetite has been primarily for government debt. The hope is that those investors will fill in once the Fed exits the MBS market. However, if private investors do not participate in the Treasury market to the same extent as before, then prices of U.S. government bonds will fall and rates will rise. If the spread between mortgage rates and Treasuries remains the same, then rates on mortgages must rise too.

Given the link between the real estate market and the overall economy, a spike in Treasury yields and mortgage rates would be a huge drag on home prices and economic growth. Since Bernanke fears deflation much more than inflation, the chances are very high that he will wait until the full effect of a fall in demand in the MBS market is realized before acting - an outcome that will be measured in months, not days.

If the Fed's departure from the MBS market plays out as I expect, the result will not only be fewer mortgage issuances but several other headwinds for the U.S. economy in 2010. Those forces, in turn, should give Bernanke cause to defy market expectations and hesitate in raising the Fed Funds rate. Not only will mortgage rates rise next year but the Fed Funds Futures market also indicates the market expects at least a small increase in the overnight lending rate sometime in the late summer or early fall. Taxes and regulations will increase at the end of the year, and we will see the end to mortgage forbearance measures that could result in many more foreclosures and millions more homes coming onto the market, according to RealtyTrac and Amherst Securities.
Adding to the Fed's problems in 2010 should be a stubbornly high inflation rate. Data released this Tuesday shows the Producer Price Index rose 1.8% in November and 2.4% over the past 12 months. Import price data released Monday shows a month-over-month increase of 1.7% and a one-year rise of 3.7%. This relatively mild-looking annual increase belies the fact that in the nine months through November, U.S. import prices surged 10.1%, according to the BLS. Year-over-year the CPI has pushed solidly into positive territory for the first time since last February and is up 1.9% over the past 12 months.

The Fed will be stuck in neutral despite the inflation data because its officials believe a high unemployment rate will prevent inflation from taking hold.

My view is that economic growth will remain below trend, a point that is supported by the oil and copper markets, which are considered economic barometers. Copper has been stuck in a trading range just above $3 a pound and oil has retreated from nearly $80 to $70 a barrel. If the economy was indeed making a V-shaped recovery, those growth sensitive commodities would be breaking out of their trading ranges, despite a modest increase in the value of the U.S. dollar.

For now the dollar is enjoying a nice bounce because traders believe the Fed will react to the latest inflation data and "less bad" economic data. The truth is the Fed knows the recovery will be weak, it is unsure how the economy will deal with rising mortgage rates and a possible resumption in home price declines. That is why Fed officials mean it when they say "the Fed Funds Rate will remain exceptionally low for an extended period of time." For once you should believe what they say and make sure your investments reflect their easy money posture.

Assuming you do, consider investing in hard assets, foreign stocks and agricultural firms, like Eldorado Gold Corp (NYSE:EGO)., Imagold Corp. (NYSE:IAG), Chemical & Mining Co. of Chile Inc. (NYSE:SQM) and Aberdeen Australia Equity Fund Inc (NYSE_AMEX:IAF).

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