The Fed looks set to start adding to its balance sheet again: How will the bank ever exit without crashing the bond market?
I think the Federal Reserve is setting up investors for a significant change in policy to be announced after tomorrow’s, Wednesday, December 12, meeting of the Fed’s Open Market Committee.
The new plan would resume the rapid growth of the Fed’s balance sheet and push it to $3 trillion sometime in 2013.
And that just makes the big problem facing the Federal Reserve and the U.S. economy even bigger. After expanding its balance sheet by buying what will soon be an additional $2 trillion in debt to help stave off the worst effects of the global financial crisis and then to support a stumbling U.S. economy, how does the Fed shrink its balance sheet back to something like normal size without crashing the U.S. and global economies?
In other words Wednesday’s Fed meeting has huge implications for bonds, inflation, interest rates and how you structure your portfolio.
The Federal Reserve’s Operation Twist is scheduled to expire in December 2012. That program to swap about $270 billion in short-term Treasuries for longer-term, five- to seven- year debt to lower longer-term interest rates in order to support the recovery of the U.S. housing sector and to stimulate U.S. economic growth is almost certain to end with the year.
But Ben Bernanke and company are also almost certain to replace Operation Twist with a new, more aggressive program of quantitative easing. The Fed is clearly worried that the debate over the fiscal cliff alone or the actual expiration of all of the Bush tax cuts, the Social Security tax reduction, extended unemployment benefits, and the automatic budget cuts imposed by the debt ceiling deal will be enough to slow the U.S. economy and could even send the United States back into recession.
The new program, recent speeches by Federal Reserve governors and basic math argue, will be an out and out plan to buy five- to seven-year Treasuries. That would continue the thrust of Operation Twist but get around a big problem that the Fed now faces. It has become increasingly hard for the Federal Reserve to sell its short-term holdings of Treasuries and to buy medium-term debt to replace them because the Fed has effectively sold most of its short-term holdings. Since September 2011 the Federal Reserve has replaced $667 billion of short-term Treasuries on its balance sheet with medium-term debt. The Fed just doesn’t have much more short-term Treasuries to sell to balance its purchase of medium-term debt.
The new program will require the further expansion of the Federal Reserve’s already massively large balance sheet of $2.85 trillion as of November 21, 2012. That level has been relatively stable since June 2011.
But the new plan would change that. The number floating around Washington and Wall Street mentions Fed buying of about $45 billion in Treasuries a month. That would easily push the Fed’s balance sheet above $3 trillion sometime in 2013.
Amazingly enough the Fed’s balance sheet was at just about $1 trillion before the start of the current recession.
The Federal Reserve’s most recent plan for shrinking its balance sheet dates back to 2011. Then the Fed projected that it might start selling off some of its holdings of Treasuries and other debt in mid-2015. That, if you remember, is also when the Fed has said it might begin raising the short-term interest rates that it directly controls. Recent announcements from the Federal Reserve’s Open Market Committee have promised that the Fed would keep short-term rates at their current 0% to 0.25% level until at least the middle of 2015.
Logically, this plan made some sense: if the economy was strong enough by mid-2015 to take the downward pressure of higher short-term rates, it should also be strong enough to face some selling by the Federal Reserve of its medium-term debt portfolio.
Why does all this matter? It all goes back to the why and how of the Federal Reserve’s manipulation of its balance sheet to begin with. By buying Treasuries or other debt in the open market, the Federal Reserve stimulates the economy by adding to the money supply and lowering the cost (interest rates) of that money. At least that’s the theory behind the Fed’s qualitative easing programs as the U.S. economy struggled to pick up speed after the Great Recession.
The Federal Reserve pays for these purchases, essentially, by creating money with the government’s printing presses. That’s why its purchases of bonds in the open market add to the money supply—those purchases are paid for with newly printed money. Seen from this perspective, the Fed’s balance sheet consists of “assets” such as Treasury bonds purchased with money conjured out of thin air.
The big problem comes when the economy starts to pick up speed. Then all that created money that was intended to speed up growth becomes the source of inflation and threatens to push up not just prices (consumer inflation) but also the prices of financial assets (asset price inflation). Neither of those types of inflation is good. The Federal Reserve has a clear mandate to fight consumer price inflation because rising prices eat away at the value of money, making the fixed returns on things like bonds less and less valuable, and reducing the value of paychecks too. Once the expectations of future inflation get ingrained, the rate of inflation can soar as everyone strives to raise prices or increase wages faster than the rate of inflation.
The Federal Reserve purports to be concerned with asset price inflation too—although in practice the U.S. central bank has been reluctant to attack asset price inflation before it produces bubbles like that in the technology sector of the stock market in 1999 and 2000 or the more recent bubble in housing prices.
I’d assume—I’d like to assume—that after presiding over the inflation and bursting of two financial market bubbles the Federal Reserve would be determined not to let its extraordinary expansion of its balance sheet produce a third bubble that would again devastate the U.S. economy. Hence the planning for an exit in mid-2015 and hence the worry about adding to the balance sheet that must be unwound.
My worry—about the financial markets and the Federal Reserve’s effect on them—focuses upon what seems an extraordinary complacency in the bond market. Bond investors know that we’re looking at higher interest rates in the future. But yet money continues to pour into the bond market and interest rates remain at astonishingly low levels. The assumption by many investors seems to be that 1) rates could go even lower on some combination of global uncertainties that maintains the U.S. role as a “safe haven,” and that 2) smart investors (which, of course, always includes the individual bond holder in question) will be able to get out before rising interest rates and/or inflation inflict real damage on bond portfolios.
In this calculation I worry that bond investors are putting too much confidence in the Fed’s promise to maintain short-term interest rates near their current 0% to 0.25% range until at least the middle of 2015.
The Federal Reserve does indeed directly control short-term rates and the central bank probably can deliver on that promise.
But the Fed doesn’t directly control medium- or long-term interest rates and those rates could well start upward while the Fed is still engaged in a quantitative program designed to lower rates and even before the Fed starts to unwind any part of its balance sheet expansion.
Looking toward the Fed’s previous goal of beginning to reduce its balance sheet by selling bonds in the open market in mid-2015, it’s only logical to ask when traders will begin to sell their bond holdings in anticipation of that move or when they will start to demand higher interest rates in compensation for greater uncertainty in Fed policy?
So what do you actually do? I think you’ve got enough lead-time to put some strategies in place.
First, I think you start to watch for signs of increasing expectations for rising interest rates not in the yield of short-term bills but in the market for three- to seven-year Treasuries. I think that’s where the interest rate turn will be apparent first and so these Treasuries are the early warning signal that you should watch.
Second, I think you re-evaluate all your recent assumptions about asset classes, returns, and risk. Bond returns have killed stock returns during this period when extraordinarily low rates have led to even more extraordinarily low rates. I don’t think you can just assume that’s the way the financial universe will work over the next 10-year cycle. (Remember that Treasuries held to maturity return your original capital on maturity; bond funds, because they constantly roll over maturities, don’t. In a period of rising interest rates bonds are safer than bond funds invested in comparable assets. And if you don’t know how to ladder the maturities of a bond portfolio, this is a very good time to learn.)
Third, if you need income to meet your goals and needs, I think you have to broaden your search parameters. PIMCO bond guru Bill Gross has moved into emerging market debt, particularly that of Mexico, for example. Closer to home, potential changes in tax rates have damped the enthusiasm for dividend paying stocks because of the possibility of a big increase in rates as a result of negotiations over avoiding the fiscal cliff. One day, believe it or not, Congress will actually make a decision and remove a great deal of the uncertainty surrounding tax rates on dividends. At that point I think you’ll start to see some of the extraordinarily large gap between yields on Treasuries and other bonds, on the one hand, and dividend stocks, on the other, start to close. It’s amazing to me that shares of Chevron (CVX) yield 3.4% when 10-year U.S. Treasuries yield 1.6%. Which would you say has better management—Chevron or the United States? Which is more likely to raise the payout on existing bonds or shares? Which has the better balance sheet and which is more likely to see a credit rating downgrade?
Fourth, I think it’s safe to assume that the Federal Reserve will not be able to manage short-term interest rates, medium-term rates, and a reduction in the size of its balance sheet without at least some occasional disruptions. Laying in a few fear and chaos hedges—gold is the easiest—comes to mind as a reasonable strategy for any portfolio.
And fifth, I think you can bet on a decline in the U.S. dollar either because the Federal Reserve can’t manage this balancing act and has to keep its balance sheet bigger than it desires for longer than it wants—therefore raising more worries among overseas investors about U.S. financial management—or because it does indeed manage to find the extraordinary skills (or luck) to reduce its balance sheet without sending the U.S. economy back into recession but that policy still produces enough of a slowdown in economic growth—slower economic growth means lower tax revenues–to turn the U.S. budget deficit and the Fed’s balance sheet back into a front burner issue.
Remember this lesson from the last two financial bubbles—the strategies and “insurance” that traders and investors rely upon to reduce losses in a crisis can actually increase the severity of the crisis. If you plan ahead—beginning now—there’s less likelihood that you’ll get caught in the stampede to an exit.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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