If the December Fed rate hike of 0.25% marks the beginning of a period of tightening, the U.S. taxpayer is about to get a very unwelcome surprise.
Now that the U.S. Federal Reserve is raising interest rates, it won't be so easy to hide the dire consequences of years of loose money policies - especially all the quantitative easing (QE).
"They've boxed themselves in and taken America on a white knuckle ride they didn't sign up for," said Money Morning Chief Investment Strategist Keith Fitz-Gerald.
You see, when the financial crisis of 2008 struck, the Fed first lowered interest rates until it got to zero, where they remained until today.
But because the U.S. economy was still sputtering despite zero interest rates, the Fed then launched QE - the mass purchasing of U.S. Treasury bonds (essentially U.S. government debt) and the toxic mortgage-backed securities that helped trigger the 2008 crisis.
The purchases added $4.5 trillion to the Fed's balance sheet, including $1.7 trillion of mortgage-backed securities.
While these assets helped the Fed keep rates low, in an era of Fed interest rate hikes, the bloated balance creates issues the agency has never before faced.
For one thing, it won't be easy to "normalize" the balance sheet back to below $1 trillion (about where it was before the 2008 crisis). To sell those assets, the Fed will need buyers.
"There's a reason the Fed is the buyer of last resort. Nobody wants this stuff," said Fitz-Gerald. He noted that the American taxpayer ultimately funded the QE purchases and will suffer the most when the Fed encounters problems unwinding those assets.
Fitz-Gerald said the big banks used the Fed and its QE program to socialize the risks they took in creating the 2008 crisis.
"They gain, but the public pays," Fitz-Gerald said. "And now the American people own a $4 trillion toxic balance sheet."
Another big problem with a Fed rate hike now is basic to bond investing: Bond prices fall when interest rates rise.
Here's what that will do to the Fed's balance sheet...
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How the December Fed Rate Hike Wreaks Havoc on the Fed's Balance Sheet
Every Fed rate hike will take another bite out of the value of the bonds sitting on the Fed's balance sheet.
A 2013 study by MCSI Inc. (NYSE: MSCI) estimated that in the most likely scenario of gradually rising interest rates and moderate economic growth, the Fed's mark-to-market loss would reach $216 billion in three years. In the worst-case scenario, the Fed's paper loss soars to $547 billion.
So if the Fed tried to normalize its balance sheet by selling these devalued bonds, it would have to eat billions in losses.
That's why you've been hearing a lot of talk lately about why a bloated Fed balance sheet may be permanently desirable. The Fed can avoid the losses by holding the bonds to maturity.
"The academicians are trying to rationalize the balance sheet now," Fitz-Gerald said. "They're like the five-year-old caught with his hand in the cookie jar."
In the meantime, the losses won't officially register because the Fed doesn't mark to market, that is, record each asset's actual market value instead of its original purchase price.
But holding the bonds to maturity means the Fed can't normalize the balance sheet back to pre-crisis levels (under $1 trillion) any time soon, and will have limited control over the pace at which the assets roll off.
A Central Bank with Negative Net Worth
At some point, the sinking bond values will drag down the Fed's balance sheet to the point where the U.S. central bank will have negative net worth.
"The minute the Fed's net worth falls toward zero on a mark-to-market basis, currency markets and bond-rating companies will know it and publicize it," Sen. Rand Paul (R-KY) wrote in a Bloomberg commentary in August. Paul is a GOP presidential candidate and long-time Fed critic.
"The Fed has never had a negative net worth, so someone is sure to question the safety of a central bank with negative net worth and its ability to run monetary policy," Paul added.
The Fed also faces a dilemma next year when $200 billion worth of its Treasuries and $300 billion worth of its mortgage-backed securities mature.
So far, the Fed has tried to maintain stability in the bond markets by purchasing new securities to replace expiring ones. But next year's "balance sheet cliff" will make it harder for the Fed to manage, particularly in an era of Fed rate hikes.
If the Fed's balance sheet shrinks too rapidly, interest rates outside its control could spike, crushing stocks and the U.S. economy.
"The Fed has handcuffed itself and must be very careful when trying to exit the market," Andrew Szczurowski, vice president and fund manager at Eaton Vance, told Reuters. "Because the last thing it wants is for spreads to blow out on MBS and mortgage rates to rise substantially."
And there are more wild cards. Others who have large holdings of U.S. Treasuries, such as China, are likely to start unloading them more quickly now that we've had a Fed rate hike. Unlike the Fed, they have little incentive to hang onto a depreciating asset.
But more Treasuries floating around in the market will put more upward pressure on interest rates, further complicating the Fed's efforts to keep a lid on them.
"The true effects of all this are unknown because the Fed is navigating uncharted waters," said Fitz-Gerald.
The Stock Buyback Con Game: Stock buybacks make sense for some companies, but not for all. These days, they're often used to manipulate stock prices - and they've hit record levels lately. What's driving this growth is dangerous for you and our economy...
- Bloomberg: Why I Want More Thorough Fed Audits
- Reuters: Wary of Bond 'Cliff,' Fed Plans Cautious Cuts to Portfolio
About the Author
David Zeiler, Associate Editor for Money Morning at Money Map Press, has been a journalist for more than 35 years, including 18 spent at The Baltimore Sun. He has worked as a writer, editor, and page designer at different times in his career. He's interviewed a number of well-known personalities - ranging from punk rock icon Joey Ramone to Apple Inc. co-founder Steve Wozniak.
Over the course of his journalistic career, Dave has covered many diverse subjects. Since arriving at Money Morning in 2011, he has focused primarily on technology. He's an expert on both Apple and cryptocurrencies. He started writing about Apple for The Sun in the mid-1990s, and had an Apple blog on The Sun's web site from 2007-2009. Dave's been writing about Bitcoin since 2011 - long before most people had even heard of it. He even mined it for a short time.
Dave has a BA in English and Mass Communications from Loyola University Maryland.