The Federal Reserve, trying valiantly to stem the market forces for sometime, has now taken an extraordinary step of expanding their role in the current credit crisis. With the announcement that the Fed will lend $200 billion in cash and US Treasuries and extend the lending term from overnight to 28 days, the risk meter, which was already at High Alert, just went to Critical.

Here are the risks, as I see them, from the Fed’s latest action:

Increased Risk of Credit Malaise Continuing: By allowing brokers to swap their illiquid securities such as non-agency AAA/Aaa rated MBS for highly liquid UST (U.S. Treasuries) and cash, the Fed is in essence injecting $200 billion directly into the system. While this will have an immediate uplifting effect on the market, it will soon wear off as investors see additional signs of economic softening. Much like a junkie, it will require even more potent capital injection to achieve the same ‘high’.

Increased Risk to the U.S. Treasuries: The injection of $200 billion in cash and UST into the market will result in the reduction of the perceived value of the UST by the international investors. The perception of lower value of the UST is the direct result of the Fed’s announcement that it will accept AAA/Aaa rated non-agency MBS as collateral for the 28-day loan. Since investors know that the credits rating on the non-agency MBS bonds are suspect, the market for them is illiquid. However, since the Fed is willing to accept the face value of them as collateral for UST or cash, it creates a perception in the international investment community that the U.S. Government is resorting to irrational measures to save its economy. Due to the negative perception that the U.S. may be over-extending itself, foreign investors, who otherwise may have bought UST, will instead stop buying or will demand a lower price for the UST, driving the yield higher.

Increased Risk to the U.S. dollar: Fed’s latest action is a clear signal to the international investment community that the U.S. Government will go to all lengths in trying to revive its economy, including increasing the supply of dollars through other Central Banks, such as the Bank of Canada, Bank of England, European Central Bank, and the Swiss National Bank.[i] As the supply of dollars increase worldwide, the perceived value of it will fall further against other major currencies.

Increased Risk of Hyperinflation: As the foreign exchange of the Dollar decreases against other currencies, due to increased worldwide dollar supply, cost of imports will increase while the purchasing power of the dollar will decrease. With a stalled economy, weak job market, and stagnant wages, further devaluation of the dollar will drive up the prices of goods even more. The days of $4 gallon of gas and $5 gallon of milk seems more probable now than before.

The Fed hopes that the Brokers will take the cash and UST it borrowed and lend it in the market, thereby reviving the market’s vitality. However, the Brokers are suffering from lack of capital and, given the worsening economy, are hesitant to lend. Instead, they will use the cash and UST to shore up their balance sheet, even if it is for 28 days. If the Brokers do lend the money, it will probably be to an international counterparty, whose economy is in better shape than ours. Therefore, in the end, the Fed’s action today will only increase the risks to the U.S. market while stalling the inevitable market crash for a little while longer.

[i] http://www.federalreserve.gov/newsevents/press/monetary/20080311a.htm

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