Is the U.S. Fed Making the Unthinkable Inevitable?

When the U.S. Federal Reserve met last week, it did as markets expected and decided to continue buying $85 billion of newly issued U.S. Treasury debt each month.

To put that number in perspective, the Fed is now buying almost all of the new debt issued by the U.S. Treasury. This means that the U.S. federal government is financing its massive deficits in a closed system that is not subject to market forces.

In simple terms, today, when the U.S. government needs more money, it simply sends the bill to the U.S. Treasury department, which then calls the Fed and asks it to fire up the printing presses for the required amount. (Preliminary calls like this are a good idea because it’s hard to keep enough ink on hand at the Fed these days.) No need for any messy price discovery in the bond markets, which lets investors determine yields according to the balance between supply and demand.   

In any other country it wouldn’t take long for this type of QE to end in tears. Investors would simply wake up one morning and decide that they no longer wanted to hold the profligate country’s debt, at any yield, and a credit crisis would ensue with spiking bond yields, rampant inflation and a massive currency devaluation. But America has long been the world’s dominant economy and the Greenback is the world’s reserve currency. This allows it to resist natural market forces for much longer than any other country.

The special power of being the world’s reserve currency can be plainly seen today. First, U.S. bond yields should rise as the U.S.Treasury floods the market with new debt, but they don’t because the Fed uses its closed system QE to buy the new debt at artificially low prices. Second, those massive QE programs should raise fears of future U.S. inflation and should cause investors to dump their U.S. dollars in response, but they don’t because when a crisis is looming investors crave two things: safety and liquidity.

Nothing is more liquid than the world’s reserve currency and the US dollar, in our lifetimes, has always been seen as a safe harbour. In a crisis, demand for the U.S. dollar increases and the Greenback rises, even when the crisis is of the U.S.’s own making. In this way, fear of the Fed’s ongoing money printing and of higher U.S. inflation can actually drive the Greenback up, instead of down, and can also increase demand for U.S. Treasuries, which are still seen as a safe-haven asset. Counter intuitively then, the destabilizing effects of QE actually trigger a unique support mechanism for U.S. Treasury yields and the Greenback, fueling an economic discount for both that more than offsets natural market forces.

For now.

Eventually all chickens come home to roost. It will probably take a long while yet, because the prospects of the U.S. Treasury bubble bursting and of rampant U.S. inflation are almost unthinkable. But as the Fed passes up each subsequent opportunity to slow its massive QE programs the unthinkable inches a little closer to becoming the inevitable. We live in interesting times.

Five-year Government of Canada bond yields were up seven basis points last week, closing at 1.78% on Friday. Despite this, both three- and five-year fixed-mortgage rates are falling as lenders continue to adjust to the falling bond yields we had seen several weeks prior.

Five-year variable-rate mortgages are still offered in the prime minus 0.50% range, which works out to 2.50% using today’s prime rate of 3.00%. Several shorter-term variable rates are also attractively priced at the moment.

The Bottom Line: Massive QE by the U.S. Fed has been a boon to Canadian mortgage borrowers because it has kept our fixed- and variable-rate mortgages at ultra-low levels for some time. But the longer QE continues, the greater the risk that it will one day push U.S. inflation sharply higher and trigger a spike in U.S. bond yields. I think that the U.S. dollar’s special status as the world’s reserve currency, along with the world’s continuing faith in U.S. Treasuries as a safe-haven asset, will allow the Fed to continue on its current course for some time. Canadian mortgage borrowers will continue to benefit for as long as it does, but we would be wise to remember economist Herb Stein’s famous quote: “If something cannot go on forever, it will stop.” Eventually …