The Fed's New "Direct Deposit" Plan

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Created on Thursday, 04 November 2010 15:38

Written by Sara Nunnally, Editor, Smart Investing Daily

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One of the tenets of Smart Investing Daily is not to take sides in the political arena, no matter our personal feelings. What's more useful to you is what's going to happen in the financial markets now that the Republicans have the majority in the House of Representatives and the Federal Reserve is trying to "bail out" the U.S. economy again.

So I'm not going to crow or cry in today's issue.

Let's set up the situation. The House of Representative shifted to the right on Tuesday, though the U.S. Senate is still controlled by the Democrats.

Typically the market views Republican control as good for the U.S. economy. That's why Wednesday morning was very choppy. The Dow opened roughly four points lower before climbing 30 points, and then slipping back below its opening level.

The NASDAQ barely ticked higher, and the same happened with the S&P 500.

This shared legislative power could mean a lot of political uncertainty, which is showing up in a jittery financial market.

But the other thing that might be weighing down the Dow is the Federal Reserve.

A 6.7% Boost to the Federal Deficit

Wednesday wrapped up the Federal Reserve's two-day meeting discussing how to prop up the U.S. economy. We've known for a while that the Federal Reserve has been planning on buying more government debt in order to inject fresh cash into the U.S. economy.

The amount of cash the Federal Reserve is going to throw down is $600 billion. Reuters is calling this move bold and risky.

The Fed's actions will be kind of like "direct deposit." It's planning on buying $75 billion in debt every month through the middle of 2011. That means there won't be any further announcements about this program, unless the Federal Reserve decides to buy even more.

With the federal deficit expected to total $9 trillion over the next 10 years, $600 billion is a 6.7% shot in the arm. Sure, that's money we can use right now, but what the Fed and the government don't seem to truly understand is that we're going to have to pay that back some day...

Most folks think we'll just be able to sell more U.S. Treasury bonds and notes in order to cover the debt. But that just makes more debt. It's like rolling your credit card balance onto a new card... It's still an obligation.

(Investing doesn't have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Jared Levy simplify the market with our easy-to-understand articles.)

There's a section of a book I want to share with you. It's from The Dollar Meltdown: Surviving the Impending Currency Crisis with Gold, Oil, and Other Unconventional Investments, by Charles Goyette. I included it in the book I wrote with Sandy Franks titled Barbarians of Wealth: Protecting Yourself from Today's Financial Attilas...

The government runs deficits by spending more money than it has. The government's debts are then used as collateral for the creation of new money... The greater the government's debt, the more money the Fed can create.

This system of creating money is so incredible it seems as though it were designed to hide the inflation process from the public.

The Federal Reserve has already bought $1.7 trillion in U.S. government debt and mortgage-backed bonds... So why aren't we seeing inflation?

We've been lucky so far, in that respect.

The economic troubles that have plagued the U.S. for two years have also knocked the wind out of other major economies. That means that other major currencies have also been fluctuating in response. This has effectively taken the teeth out of the falling dollar.

And that's why markets are so torn... they want the fiscal conservatism traditionally found with the Republican Party, but the Fed talk of buying more government debt is just more economic burden.

In fact, Kansas City Federal Reserve President Thomas Hoenig calls the Fed's plan to purchase more debt "a bargain... with the devil."

What This Means for Markets

From a political perspective, everything is up in the air. It could mean that certain initiatives won't make it out of the House, which means market could be in for a rough two years.

But, as reported by MarketWatch, FxPro analysts say, "On the bigger picture, the question is the extent to which this leads to policy paralysis or the president working with Republicans to reduce the deficit. Both Reagan and Clinton successfully came back from midterm defeats, so politically there's still everything to play for."

That means there will be a whole lot more emphasis placed on the Fed's decision. Translation? More debt... And next week, the U.S. Treasury is expected to auction off $72 billion in notes and bonds. They call it quarterly refunding.

Think of it as the government's bake sale.

What this does for financial markets is make them more and more uncertain. At face value, folks cheer anything that will give a temporary boost to the economy, but after that first exuberant "high" we see markets factoring in debt.

The thing is, the markets have been factoring in the Fed's announcement. For the past two months the U.S. dollar has been slipping.

In response to the Fed announcement, the Dow hit a new high for 2010. It's important to note that the Dow only closed up 26.41 points, so we'd been seeing a climb since late August.

On the other hand, the U.S. dollar fell about a percentage point against the euro. That means gold climbed nearly a percentage point, too.

I think the Dow could see some resistance here, as it closed just above the high from back in April 2010.

Watch for a pullback in the markets coming the next few days and for gold to continue trending higher. As I noted last week, now's the time to protect your gains with trailing stops or hedge positions.

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