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There is No Fed Endgame
11/05/2013 12:00 pm EST
Whenever tapering begins, the Federal Reserve will still face the bigger challenge of unwinding its $4 trillion balance sheet, writes MoneyShow's Jim Jubak, also of Jubak's Picks, and he feels that will shape the market and economy for years to come.
The financial markets are focused on guessing when the Federal Reserve will begin to reduce its $85 billion a month in asset purchases.
A move to buy fewer Treasurys and mortgage-backed securities—say, $70 billion to $75 billion a month as a first stage, instead of the current $85 billion a month—would lead, the market fears, to a rise in US interest rates and a stronger dollar that would provoke a selloff in global markets.
The consensus now says this tapering won't begin until March 2014 at the soonest, although the Fed's press release, after the October meeting of its Open Market Committee, led to a pickup among traders and investors in votes for January 2014.
The Federal Reserve itself, however, has moved on in its worries and plans. While the timing of any taper remains an unsettled issue, planning at the Fed is now concentrating on the endgame.
After building up its balance sheet to a record $3.84 trillion—including $2 trillion in Treasurys and $1.4 trillion in mortgage-backed securities—the big question, and the one with much more impact in the long-term on the US and global economies and financial markets, is how does the Fed sell these assets so it can cut its balance sheet back to normal levels?
The startling answer, that's starting to emerge from studies by the Fed's own economists, is that selling these assets isn't an option. There is no quick exit strategy for the Fed, these studies argue. The Fed—and the US economy—will be stuck with its current, (nearly $4 trillion) balance sheet for a decade or more.
And that means this Fed-driven market will be with us for years to come. Here's why, and what it means to investors.
The massive expansion
Remember that before the financial crisis, the Fed's balance sheet totaled less than $1 trillion. (In August 2007, the Fed held just $785 billion in securities of all kinds.) That has changed for the foreseeable future. As late as 2025, these studies say, the Fed will still be holding a substantial portion of the assets that it owns today.
The Fed owns so much of some classes of assets that it has become the market for those assets. Any significant effort to sell these assets would send prices down and yields up, producing big losses for the Fed.
The political effect of those losses, which would end the Fed's current contribution to the US Treasury, would be something close to a rebellion in Congress.
Therefore, the Federal Reserve really has no option, these studies say, but to hold these assets until they mature in seven, or ten, or more years.
That's the best endgame strategy open to the Fed.
Which is really frightening to me, because that strategy has, really, no endgame at all. The likelihood that the global financial system will give the Fed ten quiet years to sell down its portfolio, without a crisis that requires new purchases to backstop another financial crisis somewhere in the world, is just about nil.
I don't expect the Fed to ever say it, but these studies add up this conclusion: There is no endgame for the Fed.
Let me take you quickly through the Fed's studies of the available strategies for its balance sheet, and then suggest the effects of a lack of an endgame on the global financial system and economy.
Budgetary, political impacts
The most recent studies from the Fed's economists focus on the central bank's portfolio of mortgage-backed securities. But I think the conclusions of these studies also apply to the central bank's portfolio of Treasurys.
The newest study is a revision of a truly scary paper published in January by economists at the Fed. The January study calculated that rising interest rates—a result of the success of the Fed's policies to strengthen the economy, of the end to the Fed's program of asset purchases and of asset sales by the Fed to reduce its balance sheet—would produce unprecedented losses in the Fed's portfolio. (Rising interest rates would lower the price of existing Treasurys and mortgage-backed securities held by the Fed. For example, the price of today's ten-year Treasurys would fall by about 2% if yields rose to 2.8% from today's 2.6%. A 2% loss is big money if you hold $2 trillion in Treasurys. Holders of Treasurys are already looking at a loss of about 4.5% in 2013.)
Those losses would have a huge impact on the politics of the US budget. Last year, the Fed earned a profit of $88.4 billion, with about $68 billion of that coming from income from its holdings of Treasurys. That money finds its way in the US Treasury, helping to reduce the US budget deficit. If interest rates rise, and the Fed is looking at losses, instead of income from its portfolio, those payments would come to an end—for as long as six years, the Fed's January study concluded.
A second paper in February looked at some of the political consequences of the end of those payments to the Treasury. The Fed's grip on policy may weaken, if losses from its portfolio coincide with a high US budget deficit and continued disagreements over the budget between the White House and Congress. It would be only reasonable to assume, in my opinion, that big portfolio losses at the Fed, that ended the Fed's payments to Treasury, would increase the already considerable opposition to Fed policies in Congress.
The Fed is aware of efforts to constrain its independence, such as Kentucky Republican Senator Rand Paul's proposed legislation requiring a Fed audit. Showing big portfolio losses in this atmosphere isn't exactly a way to win friends and influence people.
NEXT PAGE: The waiting game|pagebreak|
The waiting game
All this was part of the reason that Fed chairman Ben Bernanke said last June that the central bank had abandoned its plans to eventually and gradually sell off the $1.4 trillion in mortgage-backed securities it held. Instead the bank would hold those assets until they matured.
Now a new Fed study has looked at the effect of holding mortgage-backed securities to maturity on those payments to the Treasury. That strategy would keep annual payments to the Treasury at something like their current elevated levels through 2015 before they began to decline. The trough in payments to the Treasury would come in 2018 at $17 billion. That's obviously a big reduction from the recent $88 billion, but it's not all that much below the annual average of $25 billion in the decade before the financial crisis.
These studies have focused on the Fed's $1.4 trillion portfolio of mortgage-backed securities because their prices are much more sensitive to changes in interest rates. The interest rates on the mortgages that these assets are linked to have been on a huge march upward recently and have the potential to climb much, much higher. The average 30-year fixed-rate mortgage hit a low of 3.31% in November 2012. The rate on that mortgage is now up to 4.13%. But that's still well below the average of 7.66% over the last three decades.
But I think it's only a matter of time before the Fed extends its logic to its holdings of Treasurys. The yield on the ten-year Treasury note is tracing a similar course to that on mortgage-backed securities, although a stuttering economy could send yields back down. The yield, which hit a 2013 low of 1.63%, had climbed to 2.6% as of November 1, but is being projected to fall to 2.25% if the economy slows before it moves back up toward 2.8%. That would give the Fed more time to figure out an endgame.
But it's hard for me to see how the logic that applies to the Fed's portfolio of mortgage-backed securities doesn't, at some point, apply to its portfolio of Treasurys. The Federal Reserve now owns 50% of all Treasurys maturing between ten and 15 years, according to Peter Tchir of TF Market Advisors.
Yes, the Treasury market is the most liquid in the world, but, no, the Fed won't be able to sell a $2 trillion portfolio of Treasurys without pushing interest rates higher and thus increasing its own portfolio losses.
I think it is just a matter of time before the Fed announces an intention of holding to maturity in its Treasury portfolio.
What are the effects of a policy of holding to maturity?
I can think of three.
Short-term reassurance, long-term doubts
First, I think the markets will, initially at least, find the policy reassuring. It will remove a worry that the Fed will quickly ratchet up US interest rates. And while a Fed policy of holding a big portfolio of Treasurys and mortgage-backed securities doesn't add more stimulus to the global financial markets, it certainly isn't the tightening that the sale of this portfolio back into the financial markets would represent. (When the Fed buys bonds in the public markets, it increases the money supply by paying the holders of those bonds with money it has created. When the Fed sells those bonds back into the public markets, it is withdrawing the money it receives from the sale of those bonds.)
Second, if the Fed doesn't reduce its balance sheet substantially for a long period of time, it does reduce the resources it has to put to work in the next crisis. The Fed is, like it or not, the lender of last resort in any global financial crisis, and its ability to play that role depends on its ability to create liquidity and on the markets' faith that it will be able to play that role. The Fed's studies of the mortgage-backed securities market and possible hold-to-maturity strategies calculate that even by 2025, the Fed would still own $407 billion in mortgage-backed assets. That would be a big reduction from the current $1.4 trillion, but it is still $407 billion more in these securities than the Fed held before the last crisis. A hold-to-maturity strategy would also result in the Fed's portfolio remaining stuffed with Treasurys for a decade or more.
I think that will make markets jumpier in the next crisis. Investors and traders will have doubts about the Fed's ability to backstop the markets that they didn't have (or at least not to the same degree) in the global financial crisis. The odds are, then, that a hold-to-maturity strategy will increase market volatility in the next crisis.
Third, I think a hold-to-maturity strategy will distort the markets. We can already see that at work in the corporate bond market. With the Fed holding such a large percentage of ten to 15-year Treasurys, institutions, such as pension funds, and insurance companies that need longer maturities to balance their longer-term obligations, have been forced into the corporate market, with the effect of lowering yields for corporate debt in those maturities. That's one reason that companies have been issuing so much debt at these maturities—interest rates are low.
The effect of this, of course, has been to enable companies to refinance higher coupon debt at lower costs, and to add the savings to their bottom lines at a time when timeline revenue growth has faltered.
Those savings on interest payments are real, but they don't have the same long-term benefit to investors as sales growth does.
And the availability of cheaper money puts stress on corporate executives to avoid investments in capacity that are cheap to finance but that don't, in reality, have an attractive return on investment. We can see the dangers of cheap money and wishful thinking about demand in the mining industry at the moment. I don't think this will be the last sector, however, to get lured into capacity expansion that doesn't make investment sense but that is attractive because of low rates in the financial markets.
I also would expect that, gradually, a hold-to-maturity strategy would gradually raise fears of the price moves that make up inflation in the real world and asset-bubbles in the financial world. The dangers of asset-price bubbles increase if the central bank policies continue to have such negligible effects on real demand.
The era of the Fed
For the last few years investors have been living through the effects of massive expansion of central bank balance sheets. Some of us have hoped that we were headed back to something like pre-financial-crisis normal. That seems delayed, at the least.
And it increasingly looks like, rather than a return to normal, we're headed to a new stage in the saga of markets dominated by central-bank cash flows.
And, to me, unfortunately, this new stage looks like unexplored territory.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund's portfolio here.
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