The Fed’s decision last week to expand its balance sheet by $1.2 trillion through the purchase of government debt was not a big surprise for us. See the March 9^th posting “Is the Safe Trade in Treasuries Ready to Burst”. The plan the Fed laid out last Wednesday is set to expand the Fed’s purchasing of long term treasuries, MBS and debt from the GSEs.

The market reacted with exuberance as equities traded higher on the news and long term bond yields dove. In our opinion, this reaction is temporary and will likely be reversed as the Fed continues to try to artificially support government debt prices, keeping long term yields low.

Much of the commentary surrounding the Fed’s new plan was about the strong performance in the equity and government debt market. One thing that wasn’t discussed at length was the fact that the dollar took a big dive. Commodities also reacted as gold soared and oil peaked above $50, seemingly pointing to broader concerns of inflation in the future.

The Fed has been describing this process of printing more money as “credit easing” and “quantitative easing”. For the life of me I do not understand what this means. What I do understand is that bond prices and interest rates cannot he held at current artificial levels as deficit spending and the money supply continue to expand.

The retraction of the dollar and flight to commodities last week seems to back our argument of coming inflation. In our opinion the equity markets and the typical forward looking bond markets are acting irrational right now, missing what’s coming down the pike. Treasuries are yielding nothing right now and people continue to buy them; so where is the exit strategy when rates inevitably increase (induced by inflation) and prices fall.

China and other countries that have in the past supported America’s thirst for running on debt seem to be backing away from this trend, which was evidenced by the dollar trading lower over consecutive days last week. The demand for U.S. debt is waning and the Fed, although it will try, cannot fill the void.

Quantitative easing or whatever we are calling today, will likely drive demand for treasuries lower, further deteriorating the dollar and adding more support for future inflation. As we have seen recently, gold has come back in vogue as the inflation hedge trade continues, but we also like farmland in this situation, as it has performed well during inflationary periods and it produces a cash yield.

-GDH