Why the Fed Will Be Sidelined in 2010

By: Michael Pento | Tue, Dec 22, 2009
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The release of the Non-Farm Payroll Report for November along with the latest inflation data from the Bureau of Labor Statistics placed further into question the Federal Reserve's free money policy. The spate of less bad news on the economy and increases in certain price levels has brought some of the bond vigilantes back from hibernation, while the cacophony from the hard-money guys (me chief among them) to raise interest rates is growing yet louder.

But unfortunately in my opinion, the Fed will be watching the economy from the bench for nearly all of 2010. The reason is simple; the central bank already has scheduled a tremendous de facto tightening which will occur at the end of the first quarter. As most of us already know, the Fed will conclude its planned purchases of $1.25 trillion in Mortgage Backed Securities (MBS) in March. The problem is that according to the St. Louis Federal Reserve, Mr. Bernanke is responsible for 90% of the purchases of all newly issued agency MBS. That means the Fed isthe securitization market for mortgages.

Securitization has become essential to bank lending. That's because banks lend at fixed rates and borrow at floating rates. Having that ability to sell the loans allows the lender to remove it from their books and thus become more insulated from the fluctuation in interest rates. If the securitization market dries up for financial institutions, then the interest rate on those mortgage loans must rise while the amount of mortgage issuance will become attenuated.

Up until now, the appetite from fixed income investors has been primarily for sovereign debt. The hope is that those investors will supplant the Fed once they exit the MBS market. But if private investors no longer participate in the Treasury market to the same extent as before, then prices will fall and rates will rise on U.S. debt. 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 economy, the move higher in Treasury yields and mortgage rates will be a huge drag on home prices and economic growth. And since Ben Bernanke fears deflation much more than inflation, the chances are very high he will wait until the full outcome from exiting the MBS market is realized, which will be measured in months not days.

In addition to less mortgages being issued, there are several other headwinds that face the US economy in 2010. And those forces should give Mr. Bernanke cause to hold in abeyance any desire to raise the Fed Funds rate despite what markets are predicting. Not only will mortgage rates be rising next year but also; there is anticipation in the Fed Funds Futures market of at least a small increase in the overnight lending rate sometime in the late summer or early fall, taxes and regulations will be increasing at the end of the year and we will see the end of mortgage forbearance measures that--according to RealtyTrac and Amherst Securities--could dump millions more homes on the market.

Adding to the Fed's problems in 2010 should be a stubbornly high rate of inflation. Data released on Tuesday of this week showed that the PPI rose 1.8% in November and 2.4% over the last 12 months. Import prices released on Monday showed a month over month increase of 1.7% and have risen 3.7% year over year. And amazingly enough the price index for U.S. imports rose 10.1% over the last 9 months. Even year over year CPI has pushed solidly into positive territory for the first time since February of 2009, up 1.9% for the last 12 months.

But the Fed will be stuck in neutral despite the data on inflation because they believe a high rate of unemployment will prevent inflation from taking hold.

My view is that economic growth will remain below trend and that is supported by the oil and copper market, which are considered barometers for the economy. Copper has been stuck in a trading range just above $3 a pound and oil has retreated from near $80 a barrel to $70. If the economy was indeed making a "V" shaped recovery, then those growth sensitive commodities would be breaking out of their trading range, despite a modest increase in the value of the US 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, they are unsure how the economy will deal with rising mortgage rates and a possible resumption in falling home prices. That is why they 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.

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Michael Pento

Author: Michael Pento

Michael Pento
Chief Economist
Delta Global Advisors, Inc.

Michael Pento

With more than 16 years of industry experience, Michael Pento acts as chief economist for Delta Global Advisors and is a contributing writer for GreenFaucet.com. He is a well-established specialist in the Austrian School of economic theory and a regular guest on CNBC and other national media outlets. Mr. Pento has worked on the floor of the N.Y.S.E. as well as serving as vice president of investments for GunnAllen Financial immediately prior to joining Delta Global.

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