November 8, 2010

The Federal Open Market Committee statement last week contained little in the way of surprise, unless of course you bought the 30yr bond ahead of the Fed decision. The Fed announced it will buy US Treasuries to the tune of some 600 billion over the next eight months, in an attempt to spur the economy forward. The plan is simple, yet thoroughly complex: The Fed sees unemployment too high and inflation too low, and by flooding the market with additional liquidity it is hoped that banks, businesses, and borrowers will finally spend some of their cash hoard in the form of lending, hiring, and consumption.

While Bernanke and company are essentially undertaking this quantitative easing (QE2) to strengthen the US economy, the Chairman finds himself playing defendant in the court of global public opinion with this decision. If you ever needed proof that our economy is globally interconnected, you need look no further than the response of central bankers and market participants around the world, and it is anything but clear how the Fed’s decision will ultimately play out on your interest rate, currency, and commodity derivatives back home.

Emerging Markets (Currency Wars). QE2 poses enormous challenges to other central bankers. When the US floods the market with additional dollars, the excess liquidity does not respect our contiguous state boundaries, nor does it stop at our shores, but rather flows freely around the world. The US has effectively weakened the dollar against other currencies, (USD was down 3% against major currencies last week), and countries such as Brazil, China, and Thailand plan to cushion their economies from these external shocks. Non-US Nations, it seems, are also leery of a relapse into recession, and as US goods become cheaper abroad, theirs are feared to be getting more expensive to consumers in the largest market in the world. Can China now point to the Fed’s decision and claim it as “currency manipulation” when it is asked once again to let its own currency float more freely? Other central banks can follow the Fed’s example with their own asset purchases, as the Bank of England and Bank of Japan have done in the recent past. In short, countries around the globe are considering currency policy moves and protectionist measures to restore the balance. We could be in for extended volatility as Federal Reserve purchases kick in and are met with a multitude of uncoordinated, global responses.

Commodities (Ditch the Dollar). Last week crude oil hit a 6 month high topping $86 a barrel. Oil exporting nations being paid in weakened dollars is generally a recipe for higher oil prices to compensate for the loss in value. Prices could continue to rise until all Fed purchases (and global response) are known and fully factored into the price. While global demand for crude oil is still in an extended slump from the Summer 2008 peak, we should nonetheless expect the chorus to kick in and sing “ditch the dollar,” to price commodities such as crude oil in some other currency. A major subplot this time around though, is “what currency to use,” other than dollars. The last go around there was a much stronger euro to look towards, and it was given serious consideration by some, but euro zone crisis has surely diminished its appeal now. Others have suggested that oil should be priced via a basket of currencies, but the reality is that traders don’t buy and sell anything in “baskets,” they need a single currency to complete the deal. Just as in currencies, your commodity trades would be expected to see greater volatility as markets shake out and stabilize around QE2 realities. And talk of ditching the dollar in pricing commodities, if and when it arises again, will again be just talk – for now.

Interest Rates (Home Buyers and Home Wreckers). If QE2 is effective, then longer term interest rates could continue to fall or stay at low levels as the Fed dips in with asset purchases. This is great news for anyone who will buy or refinance a home, as historically low rates grease the wheels of the housing market and transactions begin to chip away at the exceedingly large inventories. But what’s good for one group could be downright disaster for another, as savers review their paltry yields and move into riskier assets as they seek higher returns. If you imagine your 90 year old grandma overweighting assets to equities or long bonds, then you get the picture. Of course, rates would only remain low so long as treasury investors stay the course and show up at auction. With US National debt approaching $13.7 trillion (fully 93% of GDP), investors may demand more return for their exposure to the US Government, and rates could easily climb in this scenario. While QE2 may have increased your pay-fixed swap liabilities in the run-up to the Fed announcement, it is anything but clear which way rates will move going forward. As with any hedge, managing your underlying risk with the right derivative instrument should still be your primary concern, and viewing swap and debt performance (for example) in tandem will give you proper perspective to navigate volatile interest rate markets ahead.

The Newly Elected (Check the Fed). The Federal Reserve is an independent financial institution of the United States, and is isolated from the winds of political change. At least that’s what we all learned in school. A wave of newly elected representatives and senators would like to tinker with the Fed’s independence. To be sure, this is not a new idea, and has been a widely held objective among a portion of the electorate. The new congress taking shape will not only renew its vows to fiscal discipline, but it may very well question Bernanke’s monetary policy decisions as well. Those who want to see a full audit of the Fed’s balance sheet could have new voice and support in the new congress. Bernanke, as student of economic history, with a deep understanding of Depression Economics, will be watched closely on his QE2 project, and only time will tell if he makes the grade or if history has another lesson in store for the Chairman and the economy.

If you have questions on how QE2 impacts your derivative portfolio, give us a call! Even though the whole world is watching this decision play out, nobody watches out for your business risks better than Chatham!

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