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What is one to make of the fact that in the US the Ten-year Treasury note has gone from 1.40% in July 2012 to 2.76% today? That is an increase of just under 100% in a little over a year. The Government of Canada 10 year benchmark bond has not been immune from the rise in interest rates. They hit their low in July 2012 as well at 1.58% and today are at 2.60% a slightly lower rise of 65%.
All of this has occurred against the backdrop of the most aggressive bond-purchasing program ever seen in the US. QE3 was announced on September 13, 2012 initially as a $40 billion per month, open-ended bond purchasing program of mortgage backed securities (MBS). On December 12, 2012, the Fed announced that they would purchase an additional $45 billion per month of open-ended purchases of US Treasury notes and bonds. The program is open-ended earning it the popular nickname of "QE to infinity".
Since the program got underway, the Fed has purchased upwards of $500 billion of US Treasury notes and bonds and over $500 billion of MBS. In some respects, that is not a lot. The US Bond market trades over $2 trillion every day. Since September 2012, US Federal debt has grown by roughly $1 trillion.
One would think that with an aggressive bond buying program plus the Fed rate being held officially at 0-0.25% (reality is that they are at 0%) that even long interest rates would stay low. They haven't. QE3 was supposed to be a program that would help grease the economy by hopefully providing easy credit to those who want it. It has not. Banks have not been lending at levels seen in the past. Foreign holders of US debt have wanted to unload their debt or at least slow their purchases. Since September 2012 foreign holdings of US debt has gone up by $116 billion (to the end of August 2013). That's not a lot considering foreigners hold roughly 32% of all US debt. Over the past year, they have purchased a bit over 10% of the net new debt. That is low when compared to earlier periods. China remains the largest foreign holder of US debt with $1,268 billion as of August 2013. Their holdings peaked in April 2013 at $1,291 billion.
A few things that have happened since QE3 got underway is the Fed's balance sheet has grown, the monetary base has grown and the US stock market appears to have been the major beneficiary of QE3. Both the Fed's balance sheet and the monetary base have increased by over $1 trillion since QE3 got underway. The stock market was wobbling in 2012 before the announcement of QE3. Since then the S&P 500 is up 20%.
What hasn't happened? The banks have not been lending to any great extent. Household debt has actually declined primarily due to a decline in mortgage debt. Falling mortgage debt appears to be running counter to what many term a strong housing market. A deeper examination of the housing market has revealed that pools of money and financial institutions have been significant buyers of distressed housing. This puts the entire housing market recovery under a cloud. On the other hand, credit card debt has gone up. Non-financial corporate debt has also gone up but the financial sector debt has fallen.
The growth in US Treasuries and MBS held by the Fed is shown below:
The problem with the rapidly growing balance sheet of the Fed is that the MBS portfolio is most likely illiquid. MBS holdings have grown from virtually none in 2008/2009 to over $1.2 trillion today. Holdings of US Treasuries are also growing up from not much over $400 billion in 2008/2009 to $2 trillion today. That is about 12% of all US Government debt. While the Fed is a long way from owning a majority of US debt and other debt the significance of this large and growing balance sheet should be viewed with concern. What does a rising interest rate environment say for this large portfolio? A half a percent interest rate increase in on the portfolio would on paper at least cause a loss estimated to be upwards of $100 billion. The capital of the Federal Reserve estimated to be about $64 billion according to the H.4.1 Factors Affecting Reserve Balances released on November 7, 2013.
With the Federal Reserve balance sheet currently at $3.8 trillion bond purchases between now and year-end should put it closer to $4 trillion. The rise in the Fed's balance sheet has largely mirrored the rise in the US stock market. At the current growth rate of the Fed's balance sheet the S&P 500 could rise to 1,800 by year-end. Talk of the "taper" is just that, talk. If the Fed were to "taper" it could cause the stock market to fall and interest rates to rise further. Amongst many of the economic concerns of the Fed has to be the declining labour force participation rate. The declining participation has played an important role in lowering the unemployment rate. If the participation rate had been maintained at levels seen back at the beginning of 2008 the US unemployment rate would be closer to 11% rather than 7.3%.
The Fed is no ordinary bank. It is private bank with its stock held by its shareholders. The US government is not a shareholder. Amongst its shareholders are some of the world's most powerful banks including JP Morgan Chase (JPM-NYSE), Citibank (C-NYSE) and Goldman Sachs (GS-NYSE). Ultimately, however, the ownership of the Federal Reserve is largely a secret. An interesting article on the Fed can be found at http://www.globalresearch.ca/who-owns-the-federal-reserve. The Fed was founded 100 years ago by the banks so that it could provide them unlimited access to cheap liquidity. It was oddly sold to the public as method of providing them with greater protection. Given that the purchasing power of the US Dollar has fallen some 97% since then it is questionable as to how much protection it has actually provided.
QE3 is a bond purchase program where the bonds are purchased mostly by the same banks that are shareholders. This is in keeping with the Fed providing an unlimited source of cheap liquidity to the banking system. The funds appear to be finding their way into the stock market or they are placed back with the Federal Reserve as reserves. The Fed pays interest on those reserves at a rate is higher than rates on US Treasury bills out one year.
The purpose of QE3 (and the earlier QE programs) was to help drive down interest costs to assist households and businesses. Evidence suggests that the funds are not reaching down to the households and businesses. If it were so household and business debt would most likely be rising. The numbers suggest that is not the case. Worse interest rates are now rising which puts upward pressure on a host of consumer and business interest rates. That would appear to work against the purpose of QE3.
Some have called QE3 the "greatest backdoor Wall Street bailout of all time". It has been suggested that the large money center banks still have billions of dollars of bad debt on their books. Acceptable accounting practices have allowed them to effectively paper over those losses. These banks are still considered "too big to fail". The largest US banks make up only about 0.2% of all banks but control some 70% of all assets. In 2008, the program initially known as the Troubled Asset Relief Program (TARP) was a bail out. Since then legislation has been passed in the US as well as the Euro Zone and Canada that would allow for a bail-in if large banks were to fail again. This model was applied to Cypriot banks when they failed during the Cyprus collapse. Depositors' funds would now be risk rather than tax payer funds.
The US economy is growing at low levels. The average growth rate over the past decade is the second lowest on record. Only the 1930's was lower. Odd considering that the market is now in its 5th year of artificially low interest rates and the most aggressive bond purchase programs ever seen. Contrary to popular opinion, the Fed cannot expand the money supply by itself. It needs the banks to do that. While the monetary base has soared money growth (M2) has been tepid. M3 that is no longer reported by the Fed actually shrunk through late 2008 and into 2010. Since its growth has also been tepid. Without strong monetary growth, the economy is not likely to grow much. Trouble is the growth would have been fueled by debt and except for government debt, debt growth has also been tepid.
With interest rates rising it puts upward pressure on all sorts of rates especially mortgages that are priced off the government bond yield curve. The ten-year US Treasury broke out of what appears as a huge head and shoulders bottom pattern. The projection on the large H&S pattern was from the ten-year Treasury note to rise to 3% as a minimum. The ten-year Treasury note did hit about 3% in early September. Since then it has rallied (yields fell, prices rose) but has now started to see yields rise once again (prices fall). There are potentially secondary objectives that could be as high as 3.60% if the ten-year were to take out the 3% objective. If that happened one would have to consider what that might do to an economy that is at best stagnant.
On the other hand if this has been a correction to a long decline in interest rates it is possible that the current back-up in interest rates could fail and rates would once again fall (prices rise). In that case minimum objectives would be a return to the neckline of the H&S pattern. That is currently near 1.90%.
It is counter intuitive that longer term interest rates have been rising in the face of the most aggressive bond purchasing program ever seen and the Fed holding interest rates artificially low at 0%. But when you have become the world's largest debtor and your economy is sputtering then it is possible that many would prefer not to be holding US Treasuries or at least buying more. And that is a problem for the world's number one economy.
