Last week, the markets were focused on the minutes from the Fed’s January 29-30 policy meeting that were made public last Wednesday. Those minutes confirmed that there are some members of the Fed Open Market Committee (FOMC) who are growing concerned about the Fed’s massive and open-ended bond buying program to the tune of $85 billion a month.
The release of the Fed minutes sent some jitters into the stock markets which saw their largest losses of the year late last week. However, Fed Chairman Ben Bernanke appeared before Congress on Tuesday and Wednesday of this week and definitely cleared the air. QE will continue indefinitely, despite the admitted risks involved in further bloating the Fed’s already $3+ trillion balance sheet.
To the surprise of few, the US stock markets exploded on the upside yesterday. After all, there is widespread agreement that the main force driving stocks higher over the last couple of years has been the Fed’s ongoing QE buying of bonds and mortgage-backed securities. The Fed has even admitted that one of the goals of QE is to push investors into “risk assets” (ie – stocks).
Despite concerns among some members of the FOMC that were revealed in last week’s minutes, Chairman Bernanke made it clear over the last two days that he is in charge of the Fed (although not in those exact words), and that QE will be continued for the foreseeable future.
“We do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more-rapid job creation.” That’s Fed-speak for more QE.
The Fed will continue its $85-billion-a-month asset purchases, he said, “until it observes a substantial improvement in the outlook for the labor market in a context of price stability.” This underscores the Fed’s recent position that it will continue QE until the unemployment rate drops to 6.5%.
Basically, Bernanke was sending a shrill message to his critics on the FOMC who believe that QE has gone too far and risks potential inflation in our future. In doing so, he also threw a big bone to stock market investors. Stocks exploded on the upside yesterday with the Dow soaring 175 points and closed at 14,075, a new high close for this year. For the year so far, the Dow is up 7.4%.
As the old saying goes, don’t fight the tape. Or in this case, don’t fight the Fed!
While it was clear that Bernanke was flexing his muscles a bit this week in his congressional testimony, and while that was another shot in the arm to the stock markets, we need to keep one thing in mind.
The Fed’s unprecedented bond buying rampage will have to end at some point. When and where it will end is unknown. Today the Fed’s balance sheet stands at just above $3 trillion. If the Fed continues buying $85 billion a month in new securities until Bernanke’s term is up at the end of January next year, the Fed’s balance sheet will be over $4 trillion.
That is what Bernanke told Congress he intends to do in his testimony earlier this week. Stocks soared, so it must be OK, right? But here’s the one thing to keep in mind: What happens when the Fed decides to sell these securities at some point? Let that sink in.
The Fed has purchased these $3 trillion (soon to be $4T) in securities in an effort to drive down long-term interest rates, and it has done so very successfully. In July of last year, the yield on the 30-year Treasury bond hit an all-time low of 2.44%, although it has since crept back up to 3.11% as of today.
So what do you think will happen whenever the Fed decides it’s time to start selling the bonds and mortgages in its portfolio? Some pretty smart minds believe that inflation will start to turn higher at some point, perhaps even before the Fed stops the unprecedented bond buying exercise. If inflation starts to rise, you know what that means for long-term interest rates.
Rates will move higher, possibly significantly higher (that would be my guess). In that case, the value of the bonds and mortgages the Fed holds will decrease, perhaps significantly. Hold that thought.
The Fed historically makes a LOT of money each year. The Fed’s annual profits are distributed to the Treasury Department. For 2012, the Fed paid the Treasury a record $89 billion in profits. Before QE started, the Fed typically made an annual profit of about one-third of that.
So what happens if interest rates rise, and the Fed’s portfolio starts to decline in value? What if the Fed actually loses money? No one knows! Will the Treasury Department have to start writing checks to the Fed to cover those losses? And does that mean that the Congress will have to appropriate taxpayer money to cover such losses? Could be.
At the end of the day, this looks like a disaster waiting to happen. Yet there are some really smart minds that don’t agree. So the government keeps racking up trillion-dollar budget deficits, and the Fed is planning to create another trillion dollars to buy more bonds and mortgages as if none of this matters.
As someone once said, “It works until it doesn’t.” Time will tell when we hit that point.