The Federal Reserve Bank (the "Fed") has been a major factor in fixed income markets since it began its controversial program called "Quantitative Easing" or QE. Most people don't know just how big. If you pay attention to the long end of the interest rate curve, you find it is so enormous as to stretch belief. The Fed now owns almost 19% of the U.S. government's $11 trillion bonds outstanding, and 40% of all issues with maturities longer than 5 years.
Source: Zero Hedge
When you put that into context with how much of the U.S. debt is held abroad, the number is downright frightening. As at September 2013 U.S. treasuries held abroad amounted to $5.7 trillion
If anyone wonders why the Fed has added mortgage backed securities to the list of target purchases for continued QE, a glance at the treasury market suggests it is not credit quality that attracted the Fed. The fact is the QE program has purchased almost all the treasury securities in existence not held by foreigners or the $2.7 trillion held by Social Security and purchases of mortgage backed securities ("MBS") may have been needed to keep their interest rates from rising to the point where banks preferred to invest in MBS than to deposit monies at the Fed, causing the Fed to have to sell bonds to meet cash calls.
The law of unintended consequences often prevails and in this case seems to have contributed to the rapid rise in housing prices fueled by record low mortgage rates. Maybe I am missing something but I thought that is how the U.S. got into this mess in the first place.
Buying is a lot easier than selling and this is going to be interesting when it unwinds.
Where has the Fed obtained the funds for this massive program? The answer is primarily from deposits by banks that in turn earn 0.25% interest on the funds they have loaned the Fed. In a nutshell, the Fed has borrowed short to lend long.
Somewhere along the line, the foreign holders are going to wake up and think "How on earth can the Fed ever unwind this situation and will we have a market for our bonds?"
The short answer is no. Any attempt to sell treasury bonds to anyone else but the Fed is going to push interest rates up and push them up quite quickly. From the makeup of the table you can see that almost everyone but the Fed has a short duration portfolio and therefore ability to just hold until they are repaid and decide not to purchase more.
It sounds so simple. But if they don't purchase who will fund the government of the United States which has to roll over about $6 trillion of short term treasuries over the next 3 years. A buyers' strike will bring this house of cards down like the Hindenberg.
At the same time you only need to look at the balance sheet of some of the United States' largest banks to see what is holding back the economy. Take much lauded JP Morgan run by Wunderkind Jamie Dimon, for example: Loans outstanding have dropped $8 billion since September 2012, but deposits with banks (read deposits with the Fed) have increased $250 billion. That is not a lot of support for business expansion leading to higher employment, whatever spin Dimon puts on it.
Where did JP Morgan get the money to lend the Fed? Customers' deposits were the biggest source, rising $141 billion. The balance of the increase in "deposits with banks" came from sales of securities (down $15 billion); trading assets (down $57 billion); and, "Federal Funds sold and securities purchased under resale agreements" (down $60 billion) with a number of odds and sods balancing the books.
To put it in ordinary English, JP Morgan has taken its customers deposits and (directly or indirectly) loaned them to the Fed for 0.25% while the Fed has taken that money to buy long treasuries and MBS.
If JP Morgan is representative of what is going on, and I suspect it is more or less representative, the rubber will hit the road when thousands of small businesses around the country start expanding and drawing on their credit lines to fund receivables and inventories at the same time as foreign investors, smelling a rise in rates, decide they have better places for their money than overvalued treasuries. The Fed will be called upon to return the "deposits" and will have to find the money. How? By selling their vast portfolio of treasuries? To whom and at what price?
When it happens, if it happens, this is going to be quite a scene.
Central bankers think they control the world. And, when they are on the "buy" side of fixed income markets, they do. It is easy to buy and there is no shortage of willing sellers when they are capitalizing future interest payments at a fraction of what would be sensible for a 10 to 30 year commitment in an uncertain world. But selling is a lot more difficult than buying and just might require lower bond prices and in turn higher interest rates to attract investors. If buyers prove hard to find, the Fed's fears of deflation could come home to roost as already slow growth meets the drag of the higher interest rates needed to sell the paper. At the same time and for the same reason, the Fed itself will have a massive "mark to market" loss on its long bonds and mortgage backed securities.
Printing money to repay the debt may not help a lot. It will definitely help stave off deflation but it will also let the inflation genie out of the bottle since it is not a step that makes typically makes foreign investors comfortable holding a country's debt. It would not be the first time in history a central banker thought they could deal with imbalances with the printing press and it did not always have a happy ending. Post World War I Germany; Mexico, Argentina and Zimbabwe have given it a shot and found the result less satisfactory than perhaps they had hoped.
It is a conundrum and a quandary, entered into perhaps without much choice but definitely harder to unwind than to set up. It may be manageable but it seems at a minimum challenging and it adds a layer of risk to equities the ebullient investor of December 2013 seems it ignore in bidding the auction ever higher with a strong conviction that the trend is your friend and you should not be dissuaded by high earnings multiples, competitive risks, or adverse trends among key customers. Just cross your fingers and keep buying.
Being old fashioned and boring, with scar tissue from my toes to my nose, I am more of a contrarian and have a large (and so far painful) short book, a lot of cash, and the greater portion of my assets invested in hard assets like debt free real estate; long lived mines and oils; and options in both directions on stocks that could be moved towards the tail end of their likely outcomes by events that seem at least possible if not probable.
This market may power higher. But it can also turn on a dime. Smart money at least recognizes the risks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.