Is the Fed Losing Control?

Ever so slightly, the S&P crept up another 0.58% last week on declining volume.  The VIX (or fear) index also contradicted the price rise; it jumped almost 5% last week.

The economic data were mostly weak, certainly not the stuff typical V-shaped recoveries–more than two years after the recession began–are made of.  Existing home sales came in at the projected level, which meant a decline from the prior month.  New home sales were projected to rise; instead they fell.  But they fell to the lowest level EVER recorded in this series, fully 13% below the same month in 2009.  Economic recoveries typically do not happen without strong new home production and sales.  Durable goods orders were weaker than expected.  Jobless claims, although lower, are remaining far above the sub-400,000 level usually associated with job creation.  GDP for Q409 was revised downward, when it was expected to remain unchanged.  This means that virtually all of the so-called growth, in the second half of 2009, was the direct result of the government’s stimulus programs.

Technically, the S&P is still very oversold, with all sorts of price and volume indicators diverging (ie. they’re pointing downward).

One of the biggest stories of the week had very little to do with the stock market or corporations in general.  The shocker had to do with the US Treasury, which auctioned off two, five and seven-year notes.  These auctions almost failed.

In fact, were it not for some mystery buyer, the auctions would have failed.  Although it’s difficult to prove (the Fed is fighting off legislative and judicial efforts to open its books), the mystery buyer is probably the Fed.

But what’s the problem if the Fed mops up all the unsold Treasury paper?  Simply put, the Fed failed to accomplish its critical mission–suppressing interest rates.  It’s not enough to buy up all the unwanted debt; the cost of the debt must be kept low. 

Instead, the two through 30 year rates ballooned, to their highest level in eight months.  But they didn’t rise for the good reasons, reasons associated with a booming economy.  They rose for ominous reasons:  widening deficits and a soaring total debt load suggest that the bond market is worried about the US drowning in sovereign debt. 

In fact, things got so bad last week that some two-year corporate bonds yielded less than two-year Treasuries.  Investors were saying that buying this investment grade corporate debt was LESS risky than lending money to the US Treasury.

And the Fed’s inability to keep rates low means that the total funding costs of the massive US debt could spiral out of control.  If rates keep climbing, the government could be forced to pay more for interest expenses, which would in turn push borrowing even higher.

That’s why the Fed must keep this genie in the bottle.  For if it escapes–and it’s already poking its head out now–the implications for our government’s finances could be catastrophic.

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