More Thoughts about the FOMC and ECB

When the FOMC first indicated it was going to expand its balance sheet by buying Treasuries, Agencies and MBS, it explained that its goal was to improve the conditions the credit markets. Observers and investors may call it QE, but to Fed officials it was credit easing.

The Fed's decision to recycle the proceeds of its maturing MBS and Agencies into Treasuries seems less motivated by that, though the FOMC was not particularly clear on its goal. Ironically, the FOMC statement was the first of the year that did not cite financial conditions. In recent weeks, bank credit appears to have increased as banks have bought a greater amount of Treasuries that have more than offset their shrinking loan book and money supply has ticked up, albeit slightly.

It is going to stabilize the size of its balance sheet and this is thought to help support the economy. As is well appreciated the Federal Reserve has a double mandate, price stability and full employment. While US interest rates have fallen since the Fed's announcement, European rates appear to be falling faster. This is what took place during the acute phase of the European debt crisis. US and German interest rates fell--the latter more than the former. This was dollar supportive.

Many observers are of two minds. On one hand there is a concern that the Fed is running out of options. This is not very persuasive. What the Fed announced yesterday does not increase its balance sheet, but it could down the road. In addition, during the Great Depression, the Federal Reserve took a greater role in the disintermediation process given that the banks were either unable or unwilling to--such as direct loans to small businesses and households. On the other hand, other observers are precisely afraid of that--that is that further weakening of the economy would prompt the Fed into more aggressive action.

The Fed is probably just as surprised as as every one else with the magnitude of the dollar's rally today. The growth concerns are not limited to the US. It is global in nature as it has been for the past three years. It comes as the rally in the foreign currencies was getting stretched from a technical point of view and interest rate spreads (US and Germany and Germany and the periphery in Europe) began shifting again (to the US vs Germany and Germany vs the periphery). The ECB had reduced its sovereign bond buying to a minimal amount, but today is the first days in a couple of weeks that it is believed to have shown its hand in a more serious way to buy Irish bonds (that is the market talk in any event).

Despite the talk of purchases, Irish 10-year bond yields are still up 11 bp today and 43 bp in the past week. Portugal and Greek bonds yields are also higher in the past five sessions as German 10-year yields are off 18 bp. While the European liquidity crisis may have ended through a combination of innovation and institutional capacity building, some investors are still concerned about solvency and this fear is being exacerbated by the heightened concern about the global economic outlook.