In Going Long, the Fed Is Short-Sighted
The Fed is clearly doing everything it can, at the expense of small savers, to provide the U.S. Treasury with minimal borrowing costs to help it finance a profligate administration and Congress.
Stock and bond traders spent most of last year in a state of high anxiety over what would happen when the Federal Reserve began “tapering” its monthly $85 billion purchases of Treasurys and mortgage-backed securities. But when the tapering was actually announced in December, the Dow Jones Industrial Average rose sharply, apparently out of relief from all the suspense. Today, after various fluctuations including last week’s swoon, the Dow is pretty much where it was back then.
The taper this month will take the purchases down to $55 billion, $30 billion in Treasurys and $25 billion in the tainted mortgage-backed securities that were the product of Uncle Sam’s “affordable housing” fiasco of the 2000s. So far, the worst fears of the markets haven’t happened.
Why not? One reason may be that the Fed isn’t tapering as much as the numbers might indicate.
While the Fed is buying fewer securities, those it is buying have longer maturities. So the Fed’s purchases, though shrinking, are relieving banks and the Treasury from a higher proportion of their risks.
Numbers compiled by the Federal Reserve bank of St. Louis record the lengthening of Treasury maturities in the Fed’s ballooning portfolio. The face value of that portfolio now stands at something over $2.3 trillion, of which bonds with maturities of more than 10 years account for 26%, compared with 18% only four years ago. Maturities between five and 10 years now account for 37%, versus 26% in 2010. But maturities from one to five years have dropped to 37% from 42%. Short-term notes, 91 days to a year, ran around 23% of holdings in the pre-2008 years. Today, they are zero.
This might all sound rather arcane, but longer maturities mean that the Fed is buying more risk. That mitigates whatever tightening effect tapering might have on the markets.
John Butler, a fund manager for Amphora Commodities in London, has commented that by buying a greater proportion of longer-dated securities from the banking system and thus relieving bankers of risk means that monetary policy may be no more tighter than it was before tapering. That would be debatable considering the substantial $10 billion increments the Fed is removing from the “buy” side of the Treasury and MBS side of the market each month. But it certainly can be said that by relieving banks and the Treasury of some of their long-term risk, the Fed is softening the market impact of tapering.
Long bonds normally return greater yields than shorter-term securities because in a fiat money system subject to bouts of inflation, they carry greater risk. Thanks in part to the Fed’s purchases, the 10-year Treasury is currently yielding less than 3%, which doesn’t offer much protection against a future inflation loss.
At the Fed’s target of 2% annual inflation (which the CPI is currently undershooting if you believe those numbers), a 10-year Treasury with a 2.75% coupon would net less than 1% at maturity. If inflation rises above 3% it becomes a loser and from 5% inflation on up it becomes a big loser. Even a one-year spike of 10% in a decade of otherwise modest inflation could produce a loss at maturity for bonds with the remarkably low coupons Treasurys carry today.
The Fed has made no secret of its plans to go long, but the whole concept of “quantitative easing,” including the term itself, is shrouded in obfuscation. While the Fed says its policies are a form of economic stimulus, any such effect is far less obvious than what is plainly visible. The Fed is clearly doing everything it can, at the expense of small savers, to provide the U.S. Treasury with minimal borrowing costs to help it finance a profligate administration and Congress.
Banks, especially the big ones, aren’t doing so badly either. According to the Federal Deposit Insurance Corp., the banking industry had record earnings of $154.7 billion in 2013. The largest, “systemically important” giants have an added fillip in that their too-big-to-fail designation and close connections with the Fed reduce their borrowing costs versus their less-favored brethren. The Fed pays a quarter of a percentage point to borrow from the banks the money it uses for supporting the Treasury and the mortgage market under “quantitative easing.” That pads bank earnings as well.
So everyone wins, right? Well, except maybe for the Fed itself, and of course savers.
The Fed has put itself in a position that offers no easy way out. If credit demand rises and that huge holding of excess bank reserves finds its way into the global economy, it could trigger inflation in excess of the Fed’s strange 2% target, and it could happen fast. The Fed could find itself sitting on a lot of devalued Treasury and mortgage-backed debt that would lose money even if held to maturity.
Who knows what the world will look like 10 years from now, or even next week? At least the Fed has an incentive to try to contain inflation. But given the size of the bank reserves already exploded by the Fed, maybe it already has failed in that task.