As you watch another act in the euro debt crisis/farce unfold in Cyprus, please remember this:
The longer the euro debt crisis rolls on, the better the chance that the Federal Reserve will be able to shrink its balance sheet without cratering the U.S. economy.
Unfortunately for the Fed (but fortunately for people who live in Spain, Italy, France, etc.), it’s unlikely that the euro debt crisis will drag on and give the Federal Reserve all the time it needs.
But, hey, ya never know. European leaders have shown a remarkable ability to drag out the crisis with partial solutions that turn out, upon examination, not to be solutions at all. Maybe they can stretch the crisis out for another three or four years.
After all this is the group that has managed to turn what should have been a crisis for the off-shore money that stuffed Cypriot banks into a referendum on the survival of the euro. And that late Sunday night produced a “solution” to the Cyprus crisis that in the not-so-long run made the crisis in Spain, Italy, France, and, especially, Greece, worse.
Maybe there’s hope for the Federal Reserve—and the U.S. economy after all. At the least, the EuroZone debt crisis should give the Fed—and U.S. stock and bond prices—valuable support through September.
Here’s the problem: The Federal Reserve to provide liquidity in the days after the collapse of Lehman Brothers, to stimulate the U.S. economy in the recovery from the financial crisis, to revive the U.S. housing market, and finally in an effort to turn a stumbling U.S. economic recovery into a self-sustaining period of growth has, to put it crudely, printed money.
Trillions of dollars.
The Fed’s actual operation is much more sophisticated than printing Jacksons and dropping them out of helicopters. The Fed buys bonds in the financial markets. That gives bondholders cash to use in buying new bonds or stocks or to spend on anything from BMWs to expanding a factory. How does the Fed pay for these assets? The Fed doesn’t have to do anything quite as concrete or primitive as printing money. It simply credits the account of the seller with the purchase price. Meanwhile so that everything adds up, the Fed adds the bonds it purchased to its balance sheet. Which means that you can track the amount of money that the Federal Reserve is adding to the money supply by looking at increases and decreases in the Fed’s balance sheet.
At the beginning of March 2013, the Federal Reserve’s balance sheet stood at $3.1 trillion. That’s a huge $2.6 trillion increase from the $488 billion balance sheet on January 19, 2011. That’s $2.6 trillion “created” and added to the U.S. and global financial system in two years.
The conventional wisdom says that the Federal Reserve needs to start reducing that balance sheet sooner rather than later. Some time soon, this wisdom says, the Fed needs to slow and then end its current program of buying $85 billion of Treasuries and mortgage-backed securities every month. Speculation is that the Fed might stop that buying in early 2014. By that point the Fed will have added another $765 billion in assets to its balance sheet pushing the total to near $4 trillion.
The next step, as early as 2014 perhaps, the Fed would actually start up reduce its balance sheet by selling some of those Treasuries and mortgage-backed securities.
The conventional wisdom holds that if the Federal Reserve doesn’t reduce its balance sheet in relatively short order two things will happen. That $3 trillion the Federal Reserve will have pumped into the money supply by the end of 2013 will start to drive up inflation as a recovering economy eats up currently excess capacity. And rising inflation plus the Fed’s selling of its portfolio will push up interest rates. It will be hard, the conventional wisdom says, to sell that $3 trillion in Treasuries and mortgage-backed securities back into private hands without giving investors some “extra” yield as a reward.
At best higher interest rates and higher inflation will act as a drag on the U.S. economy. In a slightly worse scenario higher interest rates and higher inflation would cut into growth enough to stall the economy. At worst higher interest rates would increase the cost of funding the huge federal debt to a degree that would require the kinds of budget cuts and maybe even tax increases that have turned austerity policies into recession in the EuroZone.
Some economists who have studied the structure of the Fed’s balance sheet think that this scenario could get very nasty. In an effort to drive down medium-term interest rates and to jump start the housing market by lowering mortgage rates the Federal Reserve has concentrated its buying of Treasuries in medium-term maturities. Almost half of the Fed’s $1.78 trillion portfolio of Treasuries is in maturities of 5 to 10 years. So big are the Fed’s holdings at these maturities that some economists and bond market analysts worry that the Fed has effectively become the market at these maturities. Any attempt to sell this part of the portfolio, they fear, would cause interest rates to move up very quickly since there simply aren’t enough buyers to absorb all this supply without that kind of increase in yield.
In recent weeks—most importantly in recent remarks during Fed Chairman Ben Bernanke’s Humphrey-Hawkins testimony to Congress—the Federal Reserve has indicated that it is at least thinking of an alternative to the conventional wisdom. The Fed’s thinking seems to be that selling off the portfolio at a slow enough rate to keep damage to the economy to a minimum would take so long that simply waiting for the Treasuries in the portfolio to mature and then not rolling the proceeds over into new Treasury purchases would not significantly increase the time it would take to reduce the Fed’s balance sheet to something like the pre-crisis level.
Estimates I’ve seen suggest that letting the portfolio mature would add no more than two or three years to the Fed’s time table.
We’re obviously well into wild guesswork territory here if we’re comparing some hypothetical schedule for selling down the portfolio to some hypothetical schedule for a mix of Treasury sales and portfolio run-off with Treasury maturities.
But both approaches, the conventional wisdom and the potential “let them mature” approach do have one thing in common: they get a lot easier and are a lot less risky if they can be implemented over more time rather than less. Ending the Quantitative Easing program of asset buying and then selling off part of the Fed’s portfolio of Treasuries and mortgage-backed securities is a lot less likely to crash the U.S. economy if the start of that effort can be delayed as long as possible and the effort can be stretched over as many years as possible. Same with a “let them mature” approach. This indeed only works if the Fed has lots of time.
So how does the Fed get more time?
Well, there’s remarkably little that the Federal Reserve can do itself. The Fed really only has control over short-term interest rates so there’s very little it can do to stop an increase in medium term and long-term interest rates if bond buyers decide they need higher yields to compensate for higher inflation or for a larger supply of Treasuries (and therefore depressed prices.) That’s especially true if the Fed is trapped in a scenario where it can’t go back to buying Treasuries in these maturities to reduce rates since the central bank is now trying to sell these assets.
Lower economic growth would give the Fed more time to execute its strategy of either selling or maturing. But that’s not an especially palatable alternative. Remember the Fed would like to be able to reduce its balance sheet without pushing the U.S. back into a recession of exactly the sort that all this asset buying was intended to end. That would confirm the opinion of those critics who say that the Fed’s whole quantitative easing strategy is doomed to failure because any short-term increase in economic growth will prove to be temporary. The economy will give back all those gains and more when quantitative easing ends and the Fed has to vacuum up the cash that it pumped into the economy in the first place.
If only the Fed could manage to find a way to increase demand for Treasuries. That would do the trick too. But short of increasing yields—exactly what Ben Bernanke and crew want to avoid—the Fed doesn’t have any way to increase demand for U.S. government paper.
But the right crisis here or there could do the job very nicely thank you. If another turn of the euro debt crisis sends the euro back down against the dollar and produces another flight to safety that sees bond buyers snapping up U.S. Treasuries, that would be exactly the kind of increase in demand that the Fed needs. Recent flight to safety moments have seen so much demand for Treasuries that yields have actually fallen. For example, the composite yield on Treasuries of maturities of 10 years or longer hit its 2012 low at 2.11% on July 25—just before European Central Bank President Mario Draghi’s speech promising to save the euro “whatever it takes.”
Now the Fed can’t conjure up a crisis in the EuroZone—or in some other part of the global financial system—even if it wanted to. And there’s no evidence that the Fed is wishing for another significant crisis anywhere. A crisis in another economy, especially in the economy of a major trading partner, takes a bite out of U.S. economic growth just when the Fed is trying to get that growth to self-sustaining levels. And if a crisis gets serious enough it would force the Fed back into the front lines of battle to make sure there’s enough liquidity in the global system just at a time when it is trying to reduce its role in that area.
But wished for or not, with all the nasty consequences a crisis brings, it is nonetheless true that just the right amount of crisis—enough to send some extra demand toward Treasuries on moderate amounts of fear and yet not enough to imperil U.S. economic growth or U.S. asset prices—does buy the Federal Reserve time to execute whatever exit strategy its has decided to pursue with lower risk.
I think the EuroZone should provide that kind of just right crisis weather through the German elections in September. Politics will make it impossible for EuroZone countries to make significant progress on any of the issues confronting them until after German Chancellor Angela Merkel faces German voter.
The Fed needs more time than that, however. Will the U.S. central bank get it? It depends on how deep the recession gets in France and how badly Italy and Spain miss their budget targets because of the recessions in those countries.
Through September a series of new crises in the EuroZone should be enough to keep U.S. medium and long-term interest rates low. That in turn should be enough to keep worries about a Fed exit strategy from significantly depressing U.S. stock prices.
A rally in U.S. stocks during this time period has clear sailing from monetary policy. Now all investors need is for companies to deliver earnings growth and for Washington not to do something stupid.
That doesn’t add up to the greatest odds that I’ve ever seen in favor of a rally. But it does suggest that the market stands a reasonable chance of advancing and it does tell you where the risk lies in this period.
After September’s German elections? My guess at this point is that we’ll see an outbreak of progress on EuroZone problems in the months after the election that will reduce the need for investors to seek the safety of U.S. Treasuries.
I’d certainly want to revisit the odds for another round in the EuroZone crisis and for the likelihood that the Fed might get the time it needs to execute its exit strategy in the October-December period.
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 http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own positions in any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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