The Fed And Rising Interest Rates

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 ( . 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 5^thyear 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.

Copyright 2013 All rights reserved David Chapman

General disclosures

The information and opinions contained in this report were prepared by MGI Securities. MGI Securities is owned by Jovian Capital Corporation (‘Jovian’) and its employees. Jovian is a TSX Exchange listed company and as such, MGI Securities is an affiliate of Jovian. The opinions, estimates and projections contained in this report are those of MGI Securities as of the date of this report and are subject to change without notice. MGI Securities endeavours to ensure that the contents have been compiled or derived from sources that we believe to be reliable and contain information and opinions that are accurate and complete. However, MGI Securities makes no representations or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this report or its contents. Information may be available to MGI Securities that is not reflected in this report. This report is not to be construed as an offer or solicitation to buy or sell any security. The reader should not rely solely on this report in evaluating whether or not to buy or sell securities of the subject company.

Written By: David Chapman