Talk about creating moral hazard. The Fed has cornered almost 40% of all Treasuries over 5 years in maturity. I've just discovered the killer aspect line from Quantitative Easing. The Fed's 4 years of QE, QE1, QE2, and QE3 has accumulated 36% of all Treasury securities between 5 years and 10 years in maturity plus 40% of those government bonds over 10 years in maturity as well as 25% of all the mortgage backed securities not owned by
Short of a miracle, Chairman Yellen faces one of the most imposing and possibly impossible challenges facing the financial markets over the next several years. If anything will derail the economy, force the stock market into a mighty retreat and destroy all hope of further expansion of the residential real estate market, it is the Fed's quandry over the retreat from quantitative easing. And you can be sure that the potential overhang of Treasury securities and mortgage backed bonds overhanging the market are not going to look like bargains to the cash-rich central banks of China, Japan, Russia,or to the pension funds and endowments.
Preventing a depression in 2008 looks easier and more straight-forward to me than the devilish predicament the Fed faces when QE finally is played out and the central bank is left holding a record amount of securities that one way or another are going to start losing value as the cost of money creeps higher. All geniuses need apply at Fed with their schemes to get us out of this trap. We are going to have to start looking at this problem early in 2014 without denying its severity and multiple ramifications.
I say it will be impossible to liquidate $3 trillion in any short term or medium time period without causing the bond and stock markets to crash. And it's even possible the Fed might have to position another $500 billion to $1 trillion bonds if the job numbers don't look promising.
Therefore, the Fed might be forced to hold the bonds to maturity, requiring more than a decade to see the securities run off, delivering trillions in cash to the central bank. I can't even get my head around what that predicament would mean down the road.
Or if the Fed begins to liquidate bonds and interest rates rise while the bond market declines it means that the Fed 's profits from its book will be reduced, wiping out its ability to pay a huge dividend to the Treasury for use in running the government. Honestly, I'm not going to shed that many tears for this loss, though others will be wailing and tearing out their hair.
I'm sure right now the economists at the regional Feds are writing papers to suggest the various policy choices we face. The potential nightmare I was warned about by a Wall Street elder is that once higher interest rates are a reality the Fed might face large paper losses on its portfolio of intermediate Treasuries. Thankfully it is not required to mark those securities to market and officially recognize the losses.
To complicate the challenge even more, as the Treasury continues to finance the government by selling new securities into the market at rates much higher than 2.80% for the 10 year security, the cost of financing the U.S. government rises as well. Not only does the Treasury lose income from the Fed, it then costs more to sell more securities in a falling market. So much for this bit of worrisome "forward guidance" from the Croesus Chronicles. More later when the clouds lift.
