Tale of the Tapering: Fed Is Big Loser as Markets Maneuver at Prospect of an End of Easy Money

How does an investor react to the news that a propped-up and thus over-priced asset may lose its props? His natural urge is to sell, of course, and that urge will soon be reflected in a decline in the asset’s price.So it is with Treasury bonds. When the Federal Reserve began hinting last spring that it may soon begin to “taper” its massive $85 billion monthly purchases of Treasury bonds and mortgage-backed securities, market fright was the result. The Fed purchases are the props that keep bond prices high and bond interest rates low. Despite later reassurances from the Fed that maybe the “tapering” won’t come so soon after all, Treasury prices began to fall and interest rates rise.Interest rates on the 10-year Treasury note has risen 66% since the “tapering” announcement. The big loser has been the Fed itself, which now has almost $2 trillion in Treasuries on its books. If the Fed were required to mark its securities to market, as private banks do, it would have posted a loss of $162 billion since the first quarter of this year, according to an estimate by Guggenheim partners. That number exceeds the capital of its 12 reserve banks, which is provided by member banks, and also the dividend earnings on its portfolio, which it delivers to the Treasury each year after deducting expenses.The recent experience suggests a two-fold problem that the Fed has made for itself through its blundering interventions in the bond market. When it actually starts to phase out its buying program, which is blowing up its balance sheet at an alarming rate, it will face further huge paper losses on its bond portfolio. Moreover, the recent bond decline has shaken market confidence that the Fed can control bond prices even with enormous expenditures.The Fed, unlike a normal bank, doesn’t have to acknowledge portfolio losses if it holds its bonds to maturity. And it doesn’t have to worry about liquidity because it has an exclusive right to print money. So the motto around the Fed is, “Why, me worry?” It currently finances its purchases by borrowing from the enormous excess reserves of member banks, so its support for government borrowing at this point doesn’t require excessive money printing and is thus held to be non-inflationary by the local optimists.But it is hard to believe that this unprecedented Fed venture into market manipulation can end well. If a mere hint of Fed withdrawal sends bond prices downward, what would an actual withdrawal—which has to come sometime since there surely are limits to how long the Fed can keep this wheel rolling—do to the bond market? The dollar is a mere fiat currency backed by nothing but trust. Now that we are measuring the amount of dollars in play at the Fed in trillions it raises an uncomfortable thought. We used to talk billions, now its trillions, numbers that can’t even be imagined in physical terms. That sounds a lot like inflation.

Tale of the Tapering: Fed Is Big Loser as Markets Maneuver at Prospect of an End of Easy Money

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