Wednesday, September 18, 2013

The Federal Reserve - Putting the Toothpaste Back in the Tube

The day of reckoning for the American (and by extension, world) economy looks like it is approaching.  As the Federal Reserve moves toward tapering (eventually, after today's announcement) its long-standing purchases of Treasury and mortgage securities, the economy will have to stand on its own legs as interest rates rise from their artificially low levels back to what the marketplace deems appropriate.  Despite what the Fed announces, the marketplace has already made up its mind about where rates should be as shown here:

Over the past 50 years, interest rates have only risen by more than 20 percent 16 times over a period of two hundred days.  On a percentage basis, the recent rise in interest rates has been the most violent on record, hitting just over 70 percent, and this is being reflected in the economy with dropping activity in the housing market, a downturn in consumer consumption and a rather tepid looking job creation rate.

An analysis by Scott Minerd at Guggenheim suggests that the economy will continue to struggle as it adapts to the new reality of less Federal Reserve intervention.  In the past, the real yield (after inflation is removed) for 10 year Treasuries has tracked closely with the University of Michigan Consumer Sentiment Index.  Since the fourth quarter of 2011 this relationship has broken down as the Fed's program of QE pushed out further along the yield curve in an attempt to lower long-term interest rates as shown on this graph:

With the Fed looking like it is going to ease back on its purchases, in the later part of 2013, the Consumer Sentiment Index and the real 10 year yield look like they are beginning to converge again with the current gap suggesting that the real 10 year yield will rise an additional 50 basis points when monetary policy returns to normal.  A projection by Seth Carpenter et al of the Federal Reserve Board suggests that this is what will happen to nominal 10 year Treasury rates out to 2020:

As I've discussed before, the Fed has been the biggest beneficiary of its own policies.  Prior to the Great Crisis, the liability side of the Fed's balance sheet was mainly in currency in circulation.  As QE1, 2 and 3 appeared, the liability side of the Fed's balance sheet ballooned with purchases of Treasuries and interest-bearing reserves held by depository institutions as shown here:

Here is a look at what happened to the asset side of the Fed's balance sheet since just prior to the Great Recession:

The Fed's asset balance sheet has ballooned from $869 billion in August 2007 to $3.701 trillion on September 12, 2013 as shown on this chart:

The Fed's securities profile has always carried a degree of risk since its market value can vary over time.  With the massive ballooning of the Fed's portfolio, the risks to the upside and downside are magnified like they have never been before.  Right now, the Fed holds $2.038 trillion in United States Treasuries or roughly 18 percent of all outstanding Treasuries.  Not only has the Fed's inventory of Treasuries risen, the duration of its portfolio is now at an all-time record, rising from 2.5 years in 2008 to 6.5 years now.   This factor also makes the market value of the Fed's portfolio more sensitive to interest rate changes.  On the upside, over the past three years while the Fed worked hard to push interest rates down, its portfolio of fixed income investments performed well, showing an unrealized cumulative gain of nearly $250 billion by the third quarter of 2012, once again, being the beneficiary of its own policies.

Now that we have that background, let's combine the data and outline a possible scenario of what could happen post-taper.  Since bond prices act inversely to yields, as yields rise, prices of bonds decline.  With the size of the Fed's portfolio, it faces paper losses of approximately $3 billion for every one-hundredth of a percentage point rise in interest rates.  Again, according to Guggenheim, the mark-to-market value of the Fed's portfolio fell by $192 billion between the first quarter of 2013 and the end of July, wiping out all of the unrealized gains since the Fed began its "Grand Experiment".  According to Forbes, it fell by $155 billion in May 2013 alone.  While I realize that these gains and losses are just "paper" and that the Fed does not have to mark its portfolio to market, there is a complicating factor involved as you will see.

The Fed currently claims that they will hold all of these assets until maturity, however, if conditions in the economy require relatively sudden monetary tightening (i.e. an increase in interest rates are required to reduce the risk of unexpected inflationary pressures), the Fed may be forced to sell some of its assets, potentially at a loss, putting further upward pressure on bond yields.  Right now, the Fed's capital base or capital resource is only $55 billion; this means that a continued rise in interest rates could completely wipe out the Fed's capital cushion in very short order which would make it difficult for the Fed to sell its inventory of Treasuries and other securities in an attempt to manipulate the economy.  If the losses on the Fed's portfolio exceed the interest earned on the securities it holds, the political backlash could well threaten the autonomy of America's central bank and reduce what credibility it currently has, making it increasingly difficult for the future Federal Reserve Chairperson to deal with an economic crisis down the road. 

It certainly appears that the day of reckoning for Dr. Bernanke's "Grand Experiment" is at hand and perhaps the Fed heads are now realizing that the risks involved with tapering and messing with the free market are coming home to roost and that the outcome of ending QE may not be as much fun as they'd hoped.  Ending QE may well turn out to be analagous to putting the toothpaste back into the tube; it is technically possible but it is very, very messy. 

1 comment:

  1. Looking down the road the numbers do not work. Allen H Meltzer is viewed by many economist as America’s foremost expert in monetary policy, he wrote the three-volume “A History of the Federal Reserve” and for over 25 years led the Shadow Open Market Committee, a group that meets regularly to discuss the policy of the Federal Reserve. At 85 his mind is clear, but his mood cloudy. “We’re in the biggest mess we’ve been in since the 1930s,” he recently stated. “We’ve never had a more problematic future.” For more on this subject and to clarify the size of our problems see the posts below.