Excerpt from today’s Fed statement:

“The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”

Translation of key words follows.

“Open market operations” means the Fed will print money (expand the liability side of our balance sheet) and buy these securities through the primary dealers.  We will do so for our own System Open Market Account (SOMA).  We are prepared to hold them.  This is the traditional form of monetary policy and has usually been focused on short-term treasuries.

The “size” of the Fed’s balance sheet has tripled in a matter of weeks (see www.cumber.com).  The Fed has been targeting the asset side with its special facilities.  The liability side of the balance sheet is the electronic equivalent of the printing of money to buy the assets.

“Purchase large quantities of agency debt and mortgage-backed securities” means, the Fed will go into the mortgage finance market and do whatever it takes to drive the mortgage interest rate lower.  The Fed is in partners with the Treasury and Fannie and Freddie in trying to implement a 4.5% conforming mortgage interest rate.  The Fed has unlimited power to direct newly created money to this sector.  We believe they will succeed.

“Purchase longer-term Treasury securities” means the Fed is broadcasting that it is willing to buy and hold longer-term Treasury notes and bonds.  This means the Fed is targeting two points on the yield curve.    They are targeting the short-term rate (Fed Funds) and a longer-term rate (Treasury notes).  Once it is established that the Fed is targeting two points on the yield curve, one can quickly determine all the other points on the yield curve. 

This last item is very important.  It says that the Fed will do what it needs to do to keep any inflation expectation from creeping into the pricing of longer-term Treasury notes and bonds.  The Fed is now transparent about this policy and wants to remove any market-driven guesswork.  We can expect Treasury bill rates in the US to remain between zero and something above zero, but under 1%, in the shorter-term sector for a while.  We define “a while” as most, if not all, of 2009, and maybe into 2010.  We can also now expect the longer-term Treasury notes (10-year for reference) to trade at yields somewhere between 2% on the low side and 3% on the high side, with 2.5% a good estimate of the average.  The Fed is trying to tell the market that this rate, too, will be maintained for a while.

Now that the Fed is defining the range of the yield curve, financial agents can quickly determine where they want to take risk and how to price it.  Cumberland’s strategy is to place bond positions in the longer end of the term structure and to focus on spread product.  We are buying longer-term tax-free municipal bonds and taxable bonds of investment-grade quality.  We believe that these spreads will narrow to treasuries over time, as the Fed continues to hold this policy in place. 

The Fed is inviting investors to take risk.  They are encouraging agents to move their money from the zero interest rate on cash to something else.  At Cumberland we are doing just that for our clients.