Graham’s note: this is an excerpt from a recent client note I sent out to subscribers of Private Wealth Advisory regarding the Fed’s most recent FOMC announcement: no QE 3 and extended ZIRP. Moreover, in that client letter I detail precisely how the Fed, while fearing deflation, has let inflation into the financial system as well as which investments will profit most from this. To learn more about Private Wealth Advisory, CLICK HERE.
As I predicted the US Federal Reserve disappointed in a big way with its January 25 FOMC meeting. There was no announcement of QE 3. Instead the Fed promised to maintain its Zero Interest Rate policy (ZIRP) until 2014: an innocuous and mainly symbolic gesture.
In truth the Fed is now trapped. Because of political pressure, it cannot announce QE 3 or any other large monetary program without a Crisis first erupting.
However, if the Fed were simply to announce that its view of the economy had worsened and not throw the markets a bone, then we could very well have seen a Crash in multiple asset classes as the entire financial system is trading primarily based on the notion that the Fed and other Central Banks can somehow manage to prop this house of cards up interminably.
As a result of this, we got more of the same with the Fed January FOMC: promises to act if needed, and a symbolic promise of future accommodation in the form of promising to extend ZIRP for years to come.
The reality is that the Fed is stuck in ZIRP and will never be able to leave it. In 2011, the US made $454 BILLION in interest payments. And that’s with interest rates at or near 0%.
Things are only going to get worse. According to the Congressional Budget Office, the estimated interest that will be due on the US’s debt load by 2015 will be $533 billion: an amount equal to 1/3 of all federal income taxes collected that year.
And of course, if interest rates rise in any fashion, the interest payment load will rise as well. This is part of the reason why the Fed cannot raise interest rates in the future… ever.
A second reason the Fed is trapped in ZIRP pertains to corporate leverage levels, which we detailed in an earlier issue of PWA. Any rise in interest rates, particularly on the short-end of the curve, will mean that corporations will see a massive increase in interest payments due on the $7.3 trillion in debt they currently owe. That could put a serious dent in the “earnings” side of the P/E valuations sell side analysts are touting to claim stocks are cheap today.
Finally, we need to consider the over the counter derivatives market. Currently 82% of the $248 trillion in derivatives sitting on US commercial bank balance sheets are based on interest rates. If even 2% of these contracts are “at risk” and one quarter of those “at risk” contracts blow up, you’ve wiped out all equity at the five largest US banks.
Suffice to say, the Fed doesn’t want interest rates to rise in any way shape or form.
So the Fed is trapped at a ZIRP rate and will not be raising rates until the market forces it to do so.
This in turn means that inflation, which has already crept into the financial system as a result of QE 1 and QE2, will be gaining further traction in the months to come. As I’ve stated before, inflation and deflation are not mutually exclusive. And while the Fed is focusing on stopping the dreaded debt deflation (a la 2008) hitting the financial system, it’s let the inflation genie out of the bottle resulting in higher costs of living and civil unrest around the globe.
To read the rest of this client letter, see the investments I’ve isolated that will maintain their purchasing power during inflation (they’re not Gold and Silver) and learn more about Private Wealth Advisory can help you outperform the market…