Seminal Event today

The equities and bond markets celebrated today, as they rallied when the Federal Reserve Bank announced they were going to purchase over $500 billion of mortgaged-back bonds and $300 billion of 10- and 30-year US Treasury bonds. Bond prices spiked up, as yields plummeted, in tandem with equities leaping forward. Main Street celebrated also, as mortgage rates, tied to interest rates, dropped to 4%.

However, this is premature celebration, because this will negatively impact our economy and financial systems long-term. What? Has Greg gone crazy?

No, I am not crazy--I am a student of financial history. This so-called "quantitative easing", or "monetizing the debt", is fancy-speak for "creating dollars out of thin air". This is a desperate attempt by the Fed to artificially suppress interest rates to aid in the economic recovery. The short-term result is that we will have a mild recovery as credit is loosened and liquidity is injected into the economy. But just like the real estate bubble, this will be false prosperity, as it is debt-financed. In other words, it is what got us into trouble in the first place, and this Fed action only exacerbates the problem, and prolongs this recession.

It satiates the general population because it provides a floor for our 401K's and the value of our home prices, but it is an artificial floor, and will delay the bottoming out process.

But let's look at the other side of the ledger--our nation's liabilities. This increases our nation's debt by at least another trillion dollars. This will obviously dampen future gross domestic product growth. But the most insidious unintended consequence is hyperinflation. We will now have too many dollars chasing too few resources. The proof is that the price of gold shot up $50 in a matter of minutes within the Fed's announcement.

Our parents taught us that there is no free lunch, and that we had to work for everything we received. We will all learn this lesson going forward. You can't just create dollars out of thin air and not pay the price.

My prognosis? Expect markets to rally on the short-term news. But expect future economic growth to be choked off for years. Expect inflation to soar--think the 1970's decade, when we had stagflation--stagnant growth, high unemployment, an anemic economy made worse by high inflation (and decreased consumer purchasing power). Investors lost money in equities and bonds, as inflation soared as did interest rates. Savers, investors, and retirees living on a fixed income will get crushed by inflation. Perversely enough, debtors will be rewarded, and 30-year mortgage borrowers will benefit due to deflated dollars servicing that debt. Of course, the United States is the largest debtor nation in the world, so there is one silver lining with inflation. But sovereign funds holding US Treasuries in their reserves won't be too happy left holding the bag on a declining asset.

As much as I disagree with our government's fiscal and monetary policies, I have prepared for this day for several months. I am long gold, silver, oil, commodities, and will short 30-year Treasury bonds again. Equities will rally short-term, but will decline again. That's why I am only long one biotech company that I believe will explode later this month. Otherwise, I will avoid stocks until I see blood in the streets, which I expect sometime in the future. Long-term (2-5 years out), expect rising inflation, and a bull market in hard and soft commodities.

This will put the Fed in a pickle, as they will have to raise short-term interest rates to stifle inflation. But the political will to do so will be absent, as raising rates will inhibit economic growth before it can even have a chance to recover. My prediction is that they will have to let inflation soar to aid growth and reduce the burden of our huge national debt (inflation lessens that debt level because it is paid back in the future with deflated dollars). High interest rates make that debt harder to service. Inflation becomes the lesser of two evils at that point, as inflation becomes a hidden tax on unknowing consumers. Some of you wiser (i.e. older) folks probably remember gas lines and soaring inflation in the 70's. That is a best-case scenario for us today, unfortunately.

Eventually 30-year Treasury bonds will plummet in value in the biggest bubble, as long-term interest rates soar. The Fed influences short-term interest rates with policy, but the long-end of the curve cannot be manipulated long-term. Bond markets anticipate inflation--or lack thereof. If a bond investor anticipates higher inflation, he/she will demand a higher yield to offset that inflation. Higher yields mean a lower price for that bond. That is exactly what the Chinese sovereign funds are worried about, as they hold almost a $1 trillion of our IOU's.

The effects of Fed intervention like we saw today are temporary. The short-term effects of the Fed buying US Treasuries is stimulative, but long-term, it ironically achieves the exact opposite, stoking inflation and forcing those same interest rates higher.

One can profit from this populist, but wrong-headed move by the Fed, but I will not celebrate it. Our elected government officials have doomed our economy for several years, if not for a decade.

Our government really only has two options: Inflate, or die. Obviously, they have chosen to inflate. But this option has unintended consequences down the road. Be like the Boy Scouts. Be prepared.