Monday, April 21, 2014

The Federal Reserve - The Year That Was 2013

The Federal Reserve released its Domestic Open Market Operations during 2013, summarizing its actions during the year.  This report gives us a summary of the Federal Open Market Committee's policies and how they impacted the Federal Reserve's now bloated balance sheet.

During 2013, the Fed purchased $1.02 trillion worth of longer-term securities, bringing the total size of the System Open Market Account (SOMA) to $3.8 trillion.  During 2013, the Fed purchased $543 billion worth of Treasuries bringing the total held to $2.2 trillion and $509 billion worth of agency MBS bringing the total held to $1.5 trillion (face value).  The duration of SOMA's portfolio rose from 6.3 years in 2012 to 6.8 years in 2013 with the duration of Treasuries falling from 8.2 years in 2012 to 7.6 years in 2013.  To put the current size of the Fed's balance sheet into perspective, before the financial near-collapse in 2008, the Fed's balance sheet had been hovering between $600 billion and $900 billion between 2000 and 2008, growing at a very slow and predictable rate.  

The Annual Report goes on to note the following:

"Market functioning indicators suggested no significant adverse effects from the Desk’s activity; markets appeared to absorb the volume of the Desk’s asset purchases without disruption. Nevertheless, financial markets experienced an unexpectedly sharp rise in longer-term interest rates and volatility in the late spring and throughout the summer in part as investors reportedly perceived communications from Federal Reserve officials as signalling a somewhat earlier withdrawal of policy accommodation than previously expected."

The brilliant minds at the Fed totally missed the boat on the sudden rise in interest rates in mid-2013 which pushed SOMA's portfolio to a loss position, albeit an unrealized loss position.  On the upside for investors, the Fed notes the following:

"The sensitivity of the market value of the portfolio to interest rate movements is in part a reflection of the interest rate risk that the Federal Reserve has moved onto its balance sheet and away from private investors—a key channel through which its asset purchase programs are believed to provide policy accommodation. Moreover, absent any actual sales of assets from the Federal Reserve’s portfolio, unrealized gains and losses have no effect on the portfolio’s income or the Federal Reserve’s remittances to the U.S. Treasury Department. In fact, the large size of the SOMA portfolio, its considerable holdings of longer-term securities, and the low interest rates paid on the Federal Reserve’s interest-bearing liabilities continued to generate high portfolio net income, which totalled $84 billion in 2013."

Isn't it kind of the Fed to take the interest rate risk on our behalf?  

Since the losses (and previous gains) were unrealized because the Fed has not started to sell its massive holdings of Treasuries and mortgage-backed securities, the Fed proudly notes that it is still raking in interest payments from the securities in its ample inventory which allowed it to earn net income of $84 billion in 2013.  But, of course, the Fed is quick to point out that it isn't in the monetary experimentation business to create a financial return on its assets since its policies are intended solely to meet the objectives of maximum employment and price stability!

Now, let's look at what the Fed was up to over the year that was 2013.

Here is a graph showing the overall size and composition of SOMA:

Again, the Fed notes that its purchases of Treasuries and agency MBS has moved some of the risk that would have been borne by individual investors onto its own balance sheet.  By purchasing longer dated securities, the Fed notes that downward pressure was placed on interest rates, reducing borrowing costs for the private sector.

Here is a chart showing SOMA's Treasury operations for 2013:

Let's look at the Treasury holdings in the Fed's balance sheet by maturity for both 2007 and 2013:

Prior to the crisis, you'll note that more than 60 percent of the Fed's holdings of Treasuries had maturities of less than three years (light blue) compared to less than 10 percent in 2013 (dark blue).

Here is a chart showing SOMA's agency MBC operations for 2013:

Here is a graph showing SOMA's Treasury holdings as a share of outstanding Treasury supply for 2011, 2012 and 2013:

I found it interesting to note that the Fed now has 45 percent of the total outstanding supply  of Treasuries with maturity dates of between ten and thirty years.  How the brain trust at the Fed can think that these purchases haven't distorted the free market is beyond my limited comprehension.

Lastly, here is a graph showing the distribution of agency mortgage-backed securities held by SOMA:

Thirty year securities accounted for 87 percent of SOMA's agency MBS holdings with two-thirds having coupons at 3.5 percent or less.  Nearly 40 percent of agency MBS held by SOMA had maturities between one and five years.  By the end of 2013, SOMA held 28 percent of outstanding fixed-rate agency MBS, up substantially from 19 percent in 2012.

Let's close with a brief look at how quickly things could happen as interest rates change and the Fed is stuck with trillions of dollars worth of securities.  The Fed saw its unrealized losses (the difference between the book value of the asset and its market value) rise to $221 billion at the end of April 2013 as the market grew increasingly certain that global monetary policy would see interest rates rise sooner rather than later and interest rates began an uncontrolled but rather tame rise from just below 2 percent to between 2.5 and 3 percent as shown on this graph:

While the unrealized losses ended up at only $53 billion by the end of 2013, the writing is on the wall.  With the Fed projecting that the SOMA portfolio will end up at $4.2 trillion by October 2014 when asset purchases end completely, it is easy to see how vulnerable the Fed will be to dropping bond prices as yields begin their slow rise to normal levels.  After all, the Fed wasn't perceptive enough to see the rapid "readjustment" that hit them in the spring of 2013 and, now that the world is in uncharted monetary territory, one has to wonder about the long-term repercussions of the Fed's bloated balance sheet and how it will react as it watches the value of its portfolio "readjust".

1 comment:

  1. What happens when the FED has realized capital losses?