Open-ended Balance Sheet Expansion

Fri, Sep 14, 2012 - 12:00am

Fed resumes balance sheet expansion and continues composition changes

During the Thursday (9/13) lunch hour EST, the Federal Reserve announced that it will resume the expansion of its balance sheet (currently at $2.867 trillion) by purchasing Agency Mortgage-Backed Securities (Agency MBSs) in the amount of $40 billion/month on an open-ended basis. Since the U.S. mortgage market increasingly over time has become a securitized one ... and in particular securitized by the nationalized debt market that is Agency issued MBS securities (as opposed to the declining private MBS market) ... Agency MBS yields have had increasingly more influence on mortgage rates than long term treasuries. Over the past couple of years, the yield spread between Agency MBSs and long term treasuries has been widening (Agency MBSs having higher yields). Some market watchers have felt (myself included) that the Fed was becoming uncomfortable with this widening yield spread and that any future monetary stimulus would come in the form of Agency MBS purchases to provide more "aid" to the housing market (even lower mortgage rates). Smart investors have been trying to front-run the Fed by establishing positions in assets that the Fed will eventually purchase. Namely, this has been intermediate to longer term treasury securities and since late last year ... Agency MBSs.

Such an investment strategy was affirmed (once again) today, representing the poor state of affairs in our financial markets. We continue to live in a global financial marketplace where the markets are increasingly driven by the actions and support of the US Federal Reserve and other major Central Banks of the world (notably the European Central Bank, The People's Bank of China, and the Bank of Japan). Markets worldwide have been unable to stand on their own, which is why we have seen such periods of volatility in response to central bank action/inaction. These monetary policies manipulate the supply of money and credit, pick winners and losers, distort the capital structure, and result in economic mal-investment creating ever increasing boom/bust cycles in terms of both magnitude and volatility.

The Fed also affirmed the continuance of several other programs ...

  • Through the end of the year, the Fed will continue to extend the maturity of its portfolio holdings by selling short term treasuries and buying an equal amount of long term treasuries (reserves neutral) at the clip of $45 billion/month ... at least until the supply of short-term treasuries in the Fed portfolio is exhausted. After that ... non-sterilized purchases of long term treasuries?
  • The Fed is extending its promise of what is essentially zero-interest rate policy (ZIRP) to mid-2015
  • The Fed will continue to re-invest principal payments from maturing Agency debt and Agency MBSs (mostly due to mortgage refinancing) into additional Agency MBSs

As I have posited for several years now, all of the Fed actions in aggregate represent the continued stealth re-capitalization of the banking system ... while at the same time an attempt to minimize the potential leakage of massive amounts of bank reserves into the economy (increasing money supply). In addition to helping the banks with their balance sheets (via outright asset purchases and now expired lending programs), the Fed continues its policy of paying banks to keep their growing excess reserves on deposit with the Fed by paying 0.25% interest on those reserves (Interest Rate on Reserves). 0.25% may not sound like much, but it is more yield than you can obtain by investing in a 2-year treasury security. Soon 0.25% may be what the 3-year treasury yields. With the Fed extending near ZIRP policy to mid-2015, interest rate risk on treasuries with maturities of three years or less is effectively eliminated (does this sound like a free market or a fixed market?). Meanwhile, with the Fed paying interest on reserves, the federal funds rate remains impotent (a cornerstone of monetary policy for the last 25 years before the financial crisis of 2008 and the introduction of interest on reserves). This is not sound stewardship and eventually even the banks will begin to have trouble with the flattening yield curve. Savers and those on fixed income are obviously penalized and are forced to engage in more risk to achieve nominal levels of return.

While the size of the Fed balance sheet (portfolio) is certainly concerning, the increase in both asset risk and interest rate risk represented in the ever-changing Fed portfolio of holdings (composition of the balance sheet) poses additional risks. It is these Fed assets that back our sovereign currency. Selling short term treasuries for long term treasuries obviously results in additional portfolio interest rate risk. Adding more long term fixed income securities in the form of Agency MBSs adds both interest rate risk and asset risk to the portfolio. A Central Bank's portfolio of assets should be very conservative. It should hold sovereign debt with maturities in the short to intermediate range, which is certainly no longer the case. It should hold Gold (which the Fed does in small amounts relative to the monetary base). Agency debt and Agency MBSs do not belong in a Central Bank portfolio, but they have become mainstream and a significant holding. This Fed is rewriting the rules and it is making some people rather uncomfortable. On some level it feels like we are on Star Trek Voyager trapped in the Delta quadrant.

It will be interesting to see how the markets digest this new open-ended policy of the Fed in the coming months. The Fed is not time-boxing themselves this time, nor are they setting a dollar limit. Meanwhile, the Fed/government is doing what it does best ... buying more time in an attempt to punt the problem further down the road. I expect the Fed balance sheet to surpass $3 trillion in the next quarter.

For additional background info, including discussions of the problems the Fed will face in the future with respect to winding down its balance sheet and potential currency/inflation problems, please refer to some of my prior essays published on Financial Sense.

About the Author

brian [dot] benton [at] gmail [dot] com ()