By Stephen McMannis, University of Pittsburgh
In no more than one paragraph, the Federal Reserve this past Tuesday described how they were able to return a record profit of $46.1 billion to the Treasury. It immediately hit the newswires, where it was at once debated on whether it was a triumph or a sign of too much government involvement.
The Fed, as described in their own words, made the majority of the “earnings on securities acquired through open market operations (U.S. Treasury securities, government-sponsored enterprise (GSE) debt securities, and federal agency and GSE mortgage-backed securities).” While, taxpayers may have breathed a sigh of relief, the Fed released its H.4.1 report on Thursday that showed the Fed, and intrinsically the taxpayer, had expanded its balance sheet to an all time record high.
Under the direction of Ben Bernanke the Fed has continued its planned purchases of GSE mortgage backed securities and Agency paper. This week alone, $60 billion in MBS were purchased along with minor additions in Agency debt. These recent additions bring the total ever closer to proposed $1.25 trillion in MBS and $175 Billion in agencies in purchase commitments. So as the Fed starts to taper off its purchases, it will be very crucial to watch how the market responds and handles existing supply.
Near the end of last year when the Fed had stated their intention to stop Treasury purchases, market participants feared/foresaw a general rise in yields. Yet since that time it has been clear that while end of the curve yields have risen (Notes and Bonds), T-Bills have continued to receive strong bids – in fact, recent auctions have shown the Bid to Cover to be over 5.00 on Bill auctions. As a result, we have seen a substantial steepening of the yield curve, especially on the back of November strong NFP report. The question remains: will we see a positive and similar response when the Fed ends its program of Quantitative Easing?
Two other things that deserve some attention on the balance sheet concern both reserve balances and repurchase agreements. The hope of any tax payer should actually be to see that the Fed is attempting to liquidate some of its holdings into the secondary markets. It can do that through direct sales off its trading desks or reverse repurchase agreements - where it essentially sells assets and effectively takes cash out the market. Yet, activity has been flat Week over Week and actually down YoY in reverse repos. Also, though somewhat unrelated, it was interesting to see that depository institutions added $110 billion to reserves at the bank. This could reaffirm the view that banks are not lending actively and continue to hoard cash (they have some incentive since the Federal Reserve does pay slight interest). Regardless of all these separate issues, the total balance sheet liabilities have grown $243 billion in a continuous transition of the contents. Over the time period, all of the short term programs have seen declines (Commercial Paper and Foreign Liquidity Swaps), while MBS and other long term initiatives have continued to swell.
In the process the balance sheet has become extremely sensitive to interest movements and although in the most primary level they control that very aspect, future “profits” are sensitive to even minor changes. Despite continued verbal statements that rates will continue to remain low for a long period of time, the Fed will not stand by and let inflation resulting from their enormous QE program go unchecked. Current responses have been to limit future purchase commitments and scale back lending under its series of temporary liquidity programs. Also, a rumor went through this week that the Fed was considering widening the band of its Funds rate to 0-.5%, which is another minor alternative to raising rates.
The reason for all this analysis of balance sheets is to show that the increased profits might not have been has great as initially stated. The Federal Reserve continues to absorb massive interest rate and default risk under its purchases; if it ever does raise rates, it will not find it as easy to dispose of those assets without taking a capital loss (yields and bond prices are have an inverse relationship). Anybody investing the markets should watch Federal Reserve activities and should pay particular attention if they hold similar assets. Lastly, I strongly believe that if the Federal Reserve does take massive losses in the years ahead, I suspect they will need to spend more than one paragraph to explain their performance.
