The curve was mixed this week as longer treasuries outperformed shorter bonds. Deflation worries and FOMC comments drove longer term rates lower as short-term rates continue to hover around record lows. More on the Fed below. MBS struggled to hang with the rally in Treasurys, as the topic of more relaxed more relaxed lending standards in the future continues to make its way around the market. Corporate bonds weakened along with stocks this week, as investors fled areas of risk in favor of government and agency debt.

The safety trade helped the Treasury sell $74 billion in coupon paying bonds this week, including a big 3-year auction that went very well right in the face of the FOMC statement on Tuesday. Concerns about a double-dip are keeping Treasurys well bid in the US, and currency concerns in Japan may lead to a boost in foreign dollar reserves and in turn heightened demand for US Government paper. The 2-year to 10-year spread currently sits at 216 basis points, a steep level historically speaking, but drastically lower than three months ago. Curve steepness is a large leading economic indicator, with steeper being better. Seeing it flatten out is not a good sign.

FOMC

Market speculation was spot on this week for what was one of the most hyped FOMC meetings in about a year. The main news from the Fed statement was the new plan to reinvest principal payments from the Agency bond and MBS portfolio into longer-term Treasurys. The New York Fed will announce that amounts to be bought each month, starting with $18 billion in the next month.

That amount is hardly QE2, since the Fed was buying Treasurys at close to twice that pace during QE1, while at the same time building a $1.25 trillion Agency portfolio. However, the move should not be ignored considering the Fed was floating strategies to reduce its portfolio through reverse repos just this Spring. The Fed is looking at the data, and is standing ready to print money in a truly unprecedented way.

I’m afraid to think about what the Fed will do next if things don’t improve. What will they buy next? Corporate debt? Stocks? Homes? Strip Malls and Office Buildings? Every time I hear an economist say, “A little inflation would be pretty nice right now!” my left eye begins to twitch a little. I agree that outright deflation is a very scary thing, but inflation by itself is also damaging. Moderate inflation as a result of real economic growth is something every economy strives for, but a Fed that targets higher levels of asset prices and works to bring interest rates extremely low in an economy that needs to shed debt to get healthy runs the heavy risk of creating inflation without growth. The stagflation scenario is getting ignored right now. By rushing to fix one problem, the Fed will inevitably create another.

Have a great weekend.