We previously wrote that the Federal Reserve's (Fed) quantitative easing program, aimed at driving fixed income asset prices higher and long-term interest rates lower, was a market corner similar to that of the Hunt Brothers' attempt with silver (www.continentalca.com/home/9252009). Given that all market corners eventually fail, the Fed's corner will as well, if for no other reason than that the Fed clearly laid out its strategy for entering and exiting the market. In contrast, during the Hunt's corner, market participants could only guess when the Hunts would exit the market.
The effectiveness of the Fed's corner is already in doubt as long-term interest rates rose during the entirety of the Fed's purchase program and recently hit new cycle highs. This means that the Fed already has losses on its holdings. Should long-term interest rates increase further the Fed will generate even greater losses. This could lead the market to question the Federal Reserve's solvency, which would dwarf the consequences of higher interest rates on an already weak housing market and heavily indebted Government.
The Fed's balance sheet is now encumbered with an additional $1.75 trillion of fixed income assets accumulated during the Fed's quantitative easing program. Figure 1 shows the growth in the Fed's securities portfolio from $500 billion at December 31, 2008 to just over $2 trillion as of March 31, 2010. This increase amounts to greater than 10% of US GDP and is nearly two times the assets of PIMCO, the world's largest bond fund manager.
Figure 1. Federal Reserve Securities Portfolio
Source: Continental Capital Advisors, Federal Reserve
Figure 2 shows the Fed's purchases of mortgage-backed securities, which increased from zero as of December 31, 2008 to over $1 trillion today. Note that $300 billion of purchases occurred during March 2009 and April 2009 when mortgages were at their highest prices/lowest yields (Figure 3). Clearly, the Fed's announcements that it planned to purchase MBS allowed market participants to front run the Fed.
Figure 2. Federal Reserve Mortgage-Backed Securities
Source: Continental Capital Advisors, Federal Reserve
As shown in Figure 3, mortgage rates have been rising since the beginning of the Fed's purchase program.
Figure 3. Mortgage Bond Yields (30 Year Fannie Mae Coupon)
Source: Bloomberg
Treasury holdings, shown in Figure 4, have increased from $400 billion to $700 billion as of March 31, 2010. As with mortgage-backed securities, Treasuries have also declined in price despite the Fed's purchases (Figure 5).
Figure 4. Federal Reserve Treasury Securities
Source: Continental Capital Advisors, Federal Reserve
Figure 5. 10-Year Treasury Yield
Source: Bloomberg
Impact of Mark-to-Market Losses on the Federal Reserve's Solvency
While most investors and commentators concentrate on the impact that higher interest rates will have on the housing market and US government finances, the mark-to-market losses of the Fed is a much more important issue because they can undermine the Fed's credibility and raise concerns about insolvency. Some investors will argue that the Fed has the ability to hold the recently accumulated securities to maturity. However, this is irrelevant if the market begins to focus on the Fed's losses as it did with Bear Stearns and Lehman Brothers.
The Fed's asset purchases have increased its leverage. Measuring the Fed's leverage by its equity/assets ratio and adjusting it for the current market value of its gold holdings, the Fed's leverage has deteriorated from nearly 20% in 2007 to 13% today (its assets/equity ratio has grown from 5x to over 7.5x) (Figure 6). If the Fed's assets were to fall by 13%, the Fed's equity would be wiped away. Importantly, a 13% decline in asset values is foreseeable. For example, if 10-year Treasury rates rise from 4% to 5.5%, the Fed would lose over 10% on its 10-year notes. Moreover, a 1.5% increase in 30-year mortgage yields would lead to a greater than 20% loss on its 30-year mortgages.
Figure 6. Federal Reserve Balance Sheet (Adjusted for Market Value of Gold)
Source: Continental Capital Advisors, Federal Reserve
Those who are not concerned about the negative consequences of money printing will argue that the Fed's solvency can never be questioned because of its ability to issue new Dollars to offset its losses. However, markets are unrelenting when the question of solvency is raised. When the Fed's solvency becomes a concern to markets, it will already be too late as the Dollar will be in freefall. The issuance of even more Dollars will be ineffective in restoring the market's confidence in the Fed.
The Fed's massive buying spree has fueled the ascent of most asset markets. While the rise in asset prices was likely the Fed's goal, the method used to achieve its goal will result in a disastrous outcome. Given that all corners fail, the Fed's attempt to corner the fixed income market will as well. Although investors are euphoric over rising stock and bond prices, sentiment will change when the Fed suffers the same fate as the Hunt Brothers.
