In previous posts I have written extensively of the intervention measures taken by the Federal Reserve, including the many risks involved with Quantitative Easing measures. One of the risks is the resulting size of the Federal Reserve’s portfolio and its inherent susceptibility to large (on a mark-to-market basis, as opposed to accounting basis) losses.
This risk greatly lacks recognition. It appears that many people discount the risk of losses, as well as the potential for the Federal Reserve to exhaust its capital base, as they figure that the Treasury can always replenish the capital. However, I believe that this reasoning is shortsighted on many fronts. Compounding the complexity of the potential for large losses in the Federal Reserve’s portfolio is the fact that any action it may take with regard to acquiring or disposing of these assets has to be weighed against the risks or damage that such acquisition or disposition incurs in the economy and/or financial markets. Given the complexity of the situation, the exceedingly large asset base and its leverage, and the uncertainties inherent in the markets – especially during times of financial stress or crises – asset acquisition, disposition, and willingness to take losses on the portfolio becomes a (very) complex matter. While I am not aware of any recent Federal Reserve statements on this matter, a FRBSF Paper of April 11, 2011 titled “The Fed’s Interest Rate Risk” (pdf) contains the following excerpts:
The Fed, of course, strives to be a cost-efficient steward of the public purse. But its statutory mandate for conducting monetary policy is to promote maximum employment and price stability. These macroeconomic goals are the key metrics for judging monetary policy. Financial considerations—even potentially large capital losses—are secondary.
also (under “Conclusion”) :
In its policy actions, the Fed’s primary focus has been on restoring the economy to health and maintaining low inflation. The Fed’s recent securities purchases appear likely to register financial gains, though these are at risk if interest rates rise. However, as then-professor Ben Bernanke (2000) wrote: For a central bank “to allow consideration of possible capital losses to block needed policy actions is misguided.” That is, interest rate risk should be a secondary consideration, subordinate to the macroeconomic goals of monetary policy.
There is also the possibility of exit from QE under exigent circumstances, which represents an adverse scenario fraught with peril.
Accentuating the dangers of the situation are the fact that interest rates are (depending upon the specific instrument) very near – or at – very-long term lows and my assessment (also held by many) that the bond market is an asset bubble.
Cumberland Advisors has published a notable document explaining its CUMB-E Index (pdf) that illustrates some of the main dynamics of the Federal Reserve’s portfolio and their trends, including its capital base / leverage and its sensitivity to increases in interest rates. As of February 29, the CUMB-E Index is at .438.
One interpretation that could be made is that if this were the portfolio of a commercial bank or hedge fund, with leverage of 50+:1 and with the aforementioned sensitivities and market dynamics – it would represent an exceedingly high risk situation.
As well, there are a variety of other notable risk aspects and dangers inherent in the situation that lack recognition, which I may discuss in future writings.
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The Special Note summarizes my overall thoughts about our economic situation
SPX at 1343.36 as this post is written