Tuesday, December 16, 2008

Fed Announces ZIRP, Gold Responds

The Federal Reserve has finally launched the first of its inflationary weapons of mass destruction:

The Federal Reserve cut the main U.S. interest rate to as low as zero for the first time and shifted its focus to the amount and type of debt it buys, seeking to revive credit and end the longest slump in a quarter-century.


Meanwhile, equity markets went insane by rallying. Investors in the DJIA, S+P 500, and emerging markets all went nuts with greed (and yes, unwinding my uncovered calls on VWO cost me more than I anticipated). The only rational response was from the price of gold, which rallied in response to the Fed's slow-motion dollar devaluation.

Treasuries are about to enter an economic Twilight Zone. When interest rates go to zero, bond prices shouldn't go any higher. That's mathematically impossible based on the fundamentals of duration, but remains financially possible because the fearfulness of bond investors shifts the aggregate demand curve for T-bonds rightward. This implies that the Fed's quant easing strategy can now support a much higher volume of Treasury issuance, and the market clearing price for these T-bonds will be unnaturally high. A debt default by the U.S. government now looks much less likely. What's more likely is the social dislocation provoked by ahistorically high inflation.

Nota bene: Anthony J. Alfidi is long IAU and GDX with the expectation that the Fed will pursue further currency inflation to destroy dollar-denominated debts.