Thursday, July 4, 2013

The Inevitable Sale: The Federal Reserve Balance Sheet

The Inevitable Sale:  The Federal Reserve Balance Sheet

While I was away looking for bears in the Canadian Rockies, the bears were lurking on Wall Street. Chairman Ben Bernanke intimated that the Federal Reserve would begin to trim its $3 trillion balance sheet, which has been pumped up with long-term treasuries and mortgage securities.  The Fed’s balance sheet is three times its normal size.  Meanwhile, President Obama indicated that he’s not going to reappoint Mr. Bernanke to another term. 

Estate Assets (1999)

As a result of these statements, the stock market became much more volatile; rising and falling by a couple hundred points on almost every day during my holiday. Investors have painfully discovered the answer to the question that they systematically got wrong in FINRA’s financial literacy test (“Failing the Road Test: Americans Aren’t Equipped to Save [June 10, 2013]”): when interest rates rise, bond prices fall. Fixed income mutual funds and ETFs have declined in value.

Digging through my huge pile of unread newspapers, I found a plethora of front-page articles expressing shock and concern about Chairman Bernanke and President Obama’s statements.  Where’s the surprise on either front?  At some point, the Federal Reserve has to shrink its balance sheet.  The purchase of long-term securities was never meant as a permanent feature of the Fed’s operations.  Mr. Bernanke was stating the obvious. 

The purchases were meant to support the financial markets and restart the economy.  Mr. Bernanke has been Chairman since 2005 and is completing his second term.  He’s been in public service since 2002.  Thus, there’s nothing astonishing about the President’s comments.  It’s time for the President to select a successor.

Money managers are supposed to be the smartest people on the planet.  They’ve known that at some point the Fed would start to sell off their vast holdings (by the way, the Fed hasn’t yet started the process), and that Mr. Bernanke would not remain chairman.  You might think that money managers would have backed off their bond-buying binge months ago in the face of these obvious facts.   However, until recent weeks they were still snapping up long-term bonds with microscopic interest rates.  Now they’re dumping bonds.

The President’s apparent decision not to reappoint the Chairman isn’t a major concern.  We tend to alternatively regard our Fed Chairmen as heroes or villains.  In fact, Alan Greenspan has been tagged with both descriptions.   While Mr. Bernanke played a pivotal role in steering us through the financial crisis, he is not indispensible.

The real problem is how the Federal Reserve will slim down its balance sheet.  In order to understand the task, imagine a huge body of floodwater held behind a dam. Holding back the water enabled the people in the valley to avoid the deluge.  However, if the dam operator releases the water too quickly, the consequences will be dire.  Similarly if the Federal Reserve acts too precipitously, we could face an economy-stalling rise in interest rates, a plunge in the value of the dollar, and/or a dramatic spike in inflation. 

Thus, the Fed has a daunting challenge of slowly and tactfully releasing its vast supply of bonds into the markets.   Although this is a manageable problem, it will be painful.  The Federal Reserve is focused on the long-term wellbeing of the economy, and money managers are fixated on today’s trade, next quarter’s performance, and this year’s bonus.  These mismatched investment horizons are likely to produce wide swings in the stock market and losses in bond portfolios. 

If you thought you were done paying for the credit bubble, think again. A portion of the pain was deferred, and we’ll feel it as Wall Street jockeys to anticipate the Federal Reserve’s actions.

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