Wall Street loved the Fed's latest plan to accept mortgage-backed securities (MBS) and agency debt in exchange for up to $200bln in Treasury bonds through a weekly auction. The first such auction is scheduled for 27-Mar.

Stocks posted their biggest one-day rally in more than five years, led by the financial services sector. And why not? What a relief it must be for the likes of Citigroup, BofA, Freddie and Fannie, among others to know they will have the opportunity to offload some of the questionable assets on their balance sheets to the Fed.

The Fed is apparently only going to accept triple-A rated debt, but the way these MBSs were packaged often makes determining the content and the true rating difficult. How much risk will the Fed be taking on and at what price?

A dollar-for-dollar swap of MBSs for Treasuries certainly wouldn't make sense, but will the auction process truly result in the Fed paying a fair market value for these securities? Does that defeat the purpose of the new TSLF? If the banks make the swaps at a discount, they are still facing writedowns. Nonetheless, if I'm a bank, I'm looking to dump my riskiest assets on the Fed first.

Once these assets are on the Fed's books, what then? In a perfect world, I assume they look to sell them back to the market once the liquidity crisis has passed. However, it seems that the sheer size and scope of the Fed's actions is reflective of just how serious the problem is. What happens when/if a security on the Fed's books defaults? Do they write-down/off the asset just like a bank would?

Is the Fed now obligated to bailout the bond insurers, in order to preserve the triple-A rating of the assets that will be on their books? Monoline insurers have been fighting to maintain their own AAA ratings. Banks have been concerned that if the insurers of the debt on their books were downgraded, they would be vulnerable to significant writedowns. If a monoline went insolvent, the banks would be fully exposed to the counter-party risk. It seems like the Fed will now face the same risks.

There are many outstanding questions and my guess is that the initial euphoria of the stock market will be short-lived. The transfer of risk, resulting from irresponsible lending practices on the part of the banks, to the Fed is certainly cause for concern. I suppose 'what goes around comes around.' Many see the Fed's post-9/11 accommodative monetary policy as the root of the subprime/liquidity crisis. I think there is enough blame to go around...and then some.

Despite the unprecedented injection of liquidity in recent weeks, there still seems to be an under-current of concern about bank insolvency in the market. If a major US bank defaults, ala Northern Rock in the UK last year, confidence in the banking system and the Fed will plummet. Gold offers the best opportunity to hedge against such systemic risks.

The massive capital injections also have a debasing effect on the dollar, which is already on the ropes as a result of a crisis of confidence and expectations of lower interest rates in the US. The dollar recovered modestly yesterday on the Fed announcement, primarily as a result of position squaring in the safe-haven currencies (yen, Swiss franc). Not surprisingly, the dollar rebound proved unsustainable and the greenback is back near recent historic lows amid rumors of a major fund with liquidity issues and continued risk aversion.

Fed fund futures show that a 50bp cut is still fully priced in for next week. However, the Fed's move has reduced the odds of a jumbo 75bp ease somewhat. The implied yield on the April contract is 2.33%, suggesting the chances of a rate cut to 2.25% has dropped to 72%, from over 100% earlier in the week. Deferred contracts continue to trade below 2%.

The prospect of more interest rate cuts will continue to weigh on the dollar, as will all this newfound liquidity. As the dollar loses ground, gold will ultimately breakout of the recent range in the direction of the trend, surpassing the $1,000 level.

Gold Market Movers:

US budget deficit for Feb at 14:00ET, expected to widen to $144 bln.

US MBA mortgage market index for the week ended 07-Mar fell 1.9%. Purchase index +1.6%, refis -4.7%.

Eurozone industrial production for Jan 0.9% m/m, better than market was expecting.

Japan Q4 GDP revised to 3.5% q/q, better than expected. However, consumer confidence for Feb fell to 36.1, a five year low.

The Fed's in a desperate race with spectre of collapse

Dramatic US Fed move to unlock markets

Bull market for gold expected to continue

Will gold catch-up with crude?

Stock index futures suggest a higher open on Wall Street.

Opinions expressed in commentary on the USAGOLD.com website do not constitute an offer to buy or sell, or the solicitation of an offer to buy or sell any precious metals product, nor should they be viewed in any way as investment advice or advice to buy, sell or hold. Centennial Precious Metals, Inc. recommends the purchase of physical precious metals for asset preservation purposes, not speculation. Utilization of these opinions for speculative purposes is neither suggested nor advised. Commentary is strictly for educational purposes, and as such USAGOLD - Centennial Precious Metals does not warrant or guarantee the accuracy, timeliness or completeness of the information found here.

Pete Grant is the Senior Metals Analyst and an Account Executive with USAGOLD - Centennial Precious Metals. He has spent the majority of his career as a global markets analyst. He began trading IMM currency futures at the Chicago Mercantile Exchange in the mid-1980's. In 1988 Mr. Grant joined MMS International as a foreign exchange market analyst. MMS was acquired by Standard & Poor's a short time later. Pete spent twelve years with S&P - MMS, where he became the Senior Managing FX Strategist. As a manager of the award-winning Currency Market Insight product, he was responsible for the daily real-time forecasting of the world's major and emerging currency pairs, along with the precious metals, to a global institutional audience. Pete was consistently recognized for providing invaluable services to his clients in the areas of custom trading strategies and risk assessment. The financial press frequently reported his personal market insights, risk evaluations and forecasts. Prior to joining USAGOLD, Mr. Grant served as VP of Operations and Chief Metals Trader for a Denver based investment management firm.

-- Posted Wednesday, 12 March 2008 | Digg This Article