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The real meaning of today's FOMC announcement

By indicating that it is likely to keep the federal funds rate "at exceptionally low levels ... at least through mid-2013," the Fed has done more with a few words than it could have done with a QE3, while avoiding the need to monetize more of the Treasury's voluminous debt issues. This is big news.

By promising to keep short-term rates near zero for at least the next two years, the Fed has driven a stake through the heart of money demand. Why hold on to money if it is going to pay you almost nothing for the next two years? Why not borrow all you can (institutional investors can borrow money at close to the funds rate) and buy anything that promises to pay at least a positive yield? The 25 bps collapse in the 10-yr Treasury yield in the hour following the FOMC announcement was the market's way of understanding this. Two years of almost-zero borrowing costs means that you can "sell the curve" (bondspeak for betting on a flatter yield curve, or borrowing short and investing long) with impunity.

Initially, bond yields fell on the news that the Fed sees so much weakness in the economy that it is ready to all but guarantee very low rates for years to come. But on reflection, what the Fed has done is to jumpstart simmering inflation expectations, which will eventually steepen the long end of the curve. The Fed can control short-term rates at will, and rates out to 5 and 10 years by extension, but it can't control rates much beyond 10 years, and it certainly can't control 30-yr rates. Already today we have seen the 10-30 spread widen by almost 10 bps, reaching a new high for the year. The bond market's knee-jerk reaction to surprise Fed announcements is often wrong, and this is a case in point. Same with the equity market: the S&P 500 fell 3% in the first 30 minutes following the FOMC announcement, and has now bounced back by 5% and looks set to close the day with solid gains.

Although weakening money demand and stimulating borrowing and leveraging is not necessarily a good thing for the dollar (understandably it has fallen since the announcement), it is not necessarily a bad thing for equities. Corporate profits have been stellar, and earnings yields are pushing 8%, so borrowing money at almost-zero to buy equities is a license to print money.

Today's FOMC announcement was one of the most convincing ways to encourage people all over the world to spend their dollars and borrow more that I can imagine.

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