The Federal Reserve's Market Corner Is Over

By: Daniel Aaronson & Lee Markowitz | Fri, Apr 9, 2010
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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
Federal Reserve: Securities Held Outright
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
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)
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
Federal Reserve: US Treasury Notes
Source: Continental Capital Advisors, Federal Reserve

Figure 5. 10-Year Treasury Yield
10-Year US 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)
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.

 


 

Author: Daniel Aaronson

Daniel Aaronson
Continental Capital Advisors, LLC

Continental Capital Advisors, LLC was formed to offset the destruction of wealth caused by the global devaluation of currencies by central banks. The name Continental Capital symbolizes the 1775 US Currency, "the Continental", which was backed by nothing and quickly became devalued.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Comments within the text should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, and / or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Any action taken as a result of reading this is solely the responsibility of the reader.

Copyright 2009-2012 © Continental Capital Advisors, LLC

Author: Lee Markowitz

Lee Markowitz CFA
Continental Capital Advisors, LLC

Continental Capital Advisors, LLC was formed to offset the destruction of wealth caused by the global devaluation of currencies by central banks. The name Continental Capital symbolizes the 1775 US Currency, "the Continental", which was backed by nothing and quickly became devalued.

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Comments within the text should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, and / or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Any action taken as a result of reading this is solely the responsibility of the reader.

Copyright 2009-2012 © Continental Capital Advisors, LLC

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