Whenever tapering begins, the Federal Reserve will still face the bigger challenge of unwinding its $4 trillion balance sheet, writes MoneyShow's Jim Jubak, also of Jubak's Picks, and he feels that will shape the market and economy for years to come.
The financial markets are focused on guessing when the Federal Reserve will begin to reduce its $85 billion a month in asset purchases.
A move to buy fewer Treasurys and mortgage-backed securities—say, $70 billion to $75 billion a month as a first stage, instead of the current $85 billion a month—would lead, the market fears, to a rise in US interest rates and a stronger dollar that would provoke a selloff in global markets.
The consensus now says this tapering won't begin until March 2014 at the soonest, although the Fed's press release, after the October meeting of its Open Market Committee, led to a pickup among traders and investors in votes for January 2014.
The Federal Reserve itself, however, has moved on in its worries and plans. While the timing of any taper remains an unsettled issue, planning at the Fed is now concentrating on the endgame.
After building up its balance sheet to a record $3.84 trillion—including $2 trillion in Treasurys and $1.4 trillion in mortgage-backed securities—the big question, and the one with much more impact in the long-term on the US and global economies and financial markets, is how does the Fed sell these assets so it can cut its balance sheet back to normal levels?
The startling answer, that's starting to emerge from studies by the Fed's own economists, is that selling these assets isn't an option. There is no quick exit strategy for the Fed, these studies argue. The Fed—and the US economy—will be stuck with its current, (nearly $4 trillion) balance sheet for a decade or more.
And that means this Fed-driven market will be with us for years to come. Here's why, and what it means to investors.
The massive expansion
Remember that before the financial crisis, the Fed's balance sheet totaled less than $1 trillion. (In August 2007, the Fed held just $785 billion in securities of all kinds.) That has changed for the foreseeable future. As late as 2025, these studies say, the Fed will still be holding a substantial portion of the assets that it owns today.
The Fed owns so much of some classes of assets that it has become the market for those assets. Any significant effort to sell these assets would send prices down and yields up, producing big losses for the Fed.
The political effect of those losses, which would end the Fed's current contribution to the US Treasury, would be something close to a rebellion in Congress.
Therefore, the Federal Reserve really has no option, these studies say, but to hold these assets until they mature in seven, or ten, or more years.
That's the best endgame strategy open to the Fed.
Which is really frightening to me, because that strategy has, really, no endgame at all. The likelihood that the global financial system will give the Fed ten quiet years to sell down its portfolio, without a crisis that requires new purchases to backstop another financial crisis somewhere in the world, is just about nil.
I don't expect the Fed to ever say it, but these studies add up this conclusion: There is no endgame for the Fed.
Let me take you quickly through the Fed's studies of the available strategies for its balance sheet, and then suggest the effects of a lack of an endgame on the global financial system and economy.
Budgetary, political impacts
The most recent studies from the Fed's economists focus on the central bank's portfolio of mortgage-backed securities. But I think the conclusions of these studies also apply to the central bank's portfolio of Treasurys.
The newest study is a revision of a truly scary paper published in January by economists at the Fed. The January study calculated that rising interest rates—a result of the success of the Fed's policies to strengthen the economy, of the end to the Fed's program of asset purchases and of asset sales by the Fed to reduce its balance sheet—would produce unprecedented losses in the Fed's portfolio. (Rising interest rates would lower the price of existing Treasurys and mortgage-backed securities held by the Fed. For example, the price of today's ten-year Treasurys would fall by about 2% if yields rose to 2.8% from today's 2.6%. A 2% loss is big money if you hold $2 trillion in Treasurys. Holders of Treasurys are already looking at a loss of about 4.5% in 2013.)
Those losses would have a huge impact on the politics of the US budget. Last year, the Fed earned a profit of $88.4 billion, with about $68 billion of that coming from income from its holdings of Treasurys. That money finds its way in the US Treasury, helping to reduce the US budget deficit. If interest rates rise, and the Fed is looking at losses, instead of income from its portfolio, those payments would come to an end—for as long as six years, the Fed's January study concluded.
A second paper in February looked at some of the political consequences of the end of those payments to the Treasury. The Fed's grip on policy may weaken, if losses from its portfolio coincide with a high US budget deficit and continued disagreements over the budget between the White House and Congress. It would be only reasonable to assume, in my opinion, that big portfolio losses at the Fed, that ended the Fed's payments to Treasury, would increase the already considerable opposition to Fed policies in Congress.
The Fed is aware of efforts to constrain its independence, such as Kentucky Republican Senator Rand Paul's proposed legislation requiring a Fed audit. Showing big portfolio losses in this atmosphere isn't exactly a way to win friends and influence people.
NEXT PAGE: The waiting game
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