FED and 5 year “risk free” heading to 0% boundery

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May you live in interesting times”, so goes the English translation of a Chinese curse/proverb. And indeed we live in interesting times because the FOMC yesterday decided to shift the outlook on a 0% short term rate from 2013 to at least 2014. And at the same time, the FED made some choices on explicit inflation targeting with at least 2% being the objective. This system was pioneered by New Zealand (1990) and has some successors such as Brazil, Canada, Australia, UK and Korea.

Now presently looking at US inflation rates, the latest numbers show a 3% headline increase and a 2,2% core increase. And believe it or not but the 5 year so-called risk free interest rate dropped to 0.75% after the announcement. And when comparing to inflation – and we will be nice using core inflation – that doesn’t make too much sense with investors locking in a substantial negative real interest rate. Where we used to have an average mean 5 year real rate of 2%, we now have one of almost -1,5% :

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This is quite remarkable. Justification by the FED : still a pretty grim recovery and that will continue for quite some time. So no new expansionary measures yet but with this kind of outlook, the FED is most likely still pondering on the extras it can achieve. QE3 could still be in the cards with most likely a combination of QE1 and 2, most likely supporting the longer end of the curve as well (don’t fight the FED !!) : buying up both US Treasuries – if necessary the whole lot – and a new round of ABS purchases to help the mortgage market. Extraordinary but not unimaginable, we have seen stranger things happening over the past couple of months. And we should continue to buy this stuff at deflationary yields while insurers can hardly get 3% on 30 year maturities (in core-Europe even less). For the next incoming US president good news because free funding is still in the cards, at least during the first half of his or her tenure. Let’s just hope that the FED is not helping to self fulfill a deflationary scenario by taking this road and by this kind of more transparent communication.



Econopolis

This article was written by Econopolis

on 26 January, 2012 in Deflation, FED, Inflation, Inflation targeting about Financial Markets, US & Canada