Fed move to buy Treasuries is important

THE RETIRED INVESTOR

The recent quarter-point interest rate cut by the Federal Open Market Committee overshadowed what I believe is an even more important development.

The Fed has kicked off a series of what it called "reserve management purchases by committing" to buy $40 billion per month in short-term Treasury bills and notes.

In essence, the Fed is expanding its balance sheet by buying these securities. It was quick to point out that this was not the beginning of a quantitative easing program, which is aimed at explicitly stimulating economic activity, although it has the same impact on financial markets. In essence, the Fed is providing a steady stream of additional liquidity to markets.

Why is that so important? More liquidity means banks, corporations, stock and bond market participants - even mom and pop to some extent - can borrow more, buy more and invest more. It also will influence the direction of interest rates on the short end of the yield curve.

The Fed's reserve balances (the amount it owns in Treasuries and the like) are huge but have declined over the past three years, now totaling $2.8 trillion. Low bank reserves can sometimes cause short-term funding pressures in the financial system, but it's hard for me to believe that with that much money sloshing around the system, there should be any difficulty at all in the credit markets. Some economists say what the Fed is doing makes sense because if it expects additional economic growth in 2026, demand for reserves will need to grow as well. The Fed's action also will benefit bond yields across the board. Short-term yields dropped immediately after the announcement, but over time, even longer-dated bonds such as the U.S. 10-year Treasury bond also may decline.

Investors believe the odds of another Fed interest rate cut in the first half of next year are low, at least until a new Federal Reserve chairman takes office. However, I'm guessing the continued monthly injections of funds by the Fed will have a similar easing impact on the economy as another rate cut.

The additional liquidity also should contribute to the traditional Santa Claus rally that occurs in the last few weeks of the holiday season. It is a time when bonuses are paid, contributions are made to savings accounts, and central banks provide additional liquidity. Some of those cash flows end up in the equity markets.

Given that I am not an economist nor a monetary expert, forgive me if I go out on a limb here. Our national debt is off the charts, at more than $39 trillion. Accepted wisdom holds that to reduce debt, a combination of spending cuts, tax reforms, and economic growth strategies is essential.

The last time I looked, this government is increasing spending and reducing taxes. And while the administration is attempting to increase growth, it is still nowhere near the rate necessary to impact our debt. That leaves either default or monetizing government debt. A U.S. default would bring down the world's financial system, so I don't think that is a viable option, which leaves monetization.

Monetization is the permanent increase in the monetary base to fund the government. Any government that issues its currency can create money without limit. Monetization occurs when a central bank buys interest-bearing debt with non-interest-bearing money. It is a permanent exchange of debt for cash.

For a simpleton like me, what I see is this: The U.S. Treasury auctions off billions in short-term debt each month to fund our debt. As of Dec. 12, the U.S. central bank is now purchasing those same securities in the open market. The net result is that the interest rates the U.S. will pay for these new obligations will be lower. The government will be selling short-term paper while simultaneously buying it back. Are we seeing the first trial balloon of things to come?

The only difference between what the Fed is doing now, and monetization is the question of permanency. The Fed has not given the markets any indication of how long its government purchases will continue. And no one has even mentioned the "M" word. That is understandable given that fears of money printing would trigger a collapse in the dollar and skyrocketing gold.

I will be curious to see how and what the new Fed chief and their committee will do in May 2026. Will they extend this program or even increase its purchases. Will the U.S. Treasury continue to only auction short-term paper now that they have found a ready buyer? Questions aplenty, to keep me watching and writing.

Bill Schmick is registered as an investment adviser representative of Onota Partners Inc. in the Berkshires. His website is schmicksretiredinvestor.com. He can be reached at 413-347-2401, or email him at [email protected].