Boiling Point: Is The Fed In Over Its Head?

December 21, 2010

If yields are rising when the Fed is buying Treasury debt, what will happen when it stops?

 

The idea that the Fed can print money in perpetuity has never made a whole lot of sense to me. Market forces will ultimately prevail, no matter how hard the central bank defends some artificial level of interest rates and bond prices. We’re already seeing this in part with the backup in Treasury yields lately, as they play catch-up to the 21 percent equity rally since the end of August.

Chadd BennettSince September, the ProShares UltraShort 20+ Year Treasury (NYSEArca: TBT), a bearish ETF that offers investors twice the daily returns of its index, has risen over 20 percent, as yields on both 10- and 30-year yields have moved up over 100 basis points. The Fed’s balance sheet is now over $2.3 trillion, according to the Wall Street Journal, and is growing, with its latest efforts at quantitative easing. The Fed clearly has a lot of skin in the game.

In a report released in earlier this year, Alan Boyce, a former Fed member, estimated that for every 1 basis point rise in yields, the Fed’s portfolio of bond holdings would lose $1.5 billion. That means the recent 1 percent increase in yields just cost the Fed nearly $150 billion on a mark-to-market basis. Of course, since the Fed doesn’t have to mark to market, losses would only be “realized” if they were to sell those bonds back into the open market.

The biggest concern arises when the economy and/or inflation actually picks up enough to justify Fed tightening. Does the Fed unwind its holdings or just raise rates? Selling its holdings doesn’t seem practical since that would require taking a loss. The more likely option is the Fed holding bonds to maturity and adjusting the Fed Funds rate all the more in order to compensate.

One Big Hedge Fund

There are a few different ways to think about what the Fed has become. Is it now one large hedge fund with a massive carry trade—paying 0.25 percent on reserves and earning around 3 percent on its assets, or is it instead just a giant bank acting as a world creditor? Or, if you believe Fed Chairman Ben Bernanke truly intends to unwind the portfolio at some point, it may be more appropriate to think of its huge presence in the bond market as a giant repurchase agreement.

However you view it, the collateral values on both sides of its balance sheet—U.S. Federal Reserve notes on the liability side and Agency paper as well as U.S. Treasurys on the asset side—are acting as direct inputs and outputs of the equation. The Fed, in other words, is basically pushing on a string.

 

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