In early 2006, in testimony before the U.S. Senate, Fed Chairman Ben Bernanke told the senators that the subprime crisis had been “contained.”
If the Fed were a publicly traded company, Wall Street would trash its stock based on the credibility of management, the failure of its policies, the loss of confidence of major constituencies and a weak — if not insolvent — balance sheet.
Reason 1: Some of the FOMC Members Don’t Get It
From the minutes of the July 30-31 meeting of the Federal Open Market Committee, we find the following excerpt: “…several participants expressed confidence that the housing recovery would be resilient in the face of the higher rates….”
Thirty-year fixed mortgage rates (Freddie Mac) rose from 3.35% in May, before the Fed’s tapering announcement, to 4.58% on Aug. 22. That’s a 36.7% increase. The median price of a new home in July was $257,200, up $7,500, or 3%, from $249,700 in June. (The Fed, by the way, doesn’t believe that there is any inflation in today’s economy.)
If the typical U.S. family buying the median-priced home had purchased in May at $250,000 with a 20% down payment with a Freddie Mac 30-year fixed-rate loan, the principal and interest payment would have been $881 a month. By August, the principal and interest payment on a similar home costing the same amount with the same down payment would be $1,023 a month.
Thus, it isn’t any wonder that new home sales (based on contracts signed) plunged by 13.4% between June and July. One has to wonder about the economic competence of those “several participants.”
Reason 2: QE Has Flopped as a Growth Stimulator
A study by two Fed economists (Curdia and Ferrero), published by the Federal Reserve Bank of San Francisco Aug. 12, concludes that “asset-purchased programs, [i.e., , quantitative easing] appear to have, at best [emphasis added], moderate effects on economic growth….”
The authors found that in the QE2 program, the asset purchases alone added only .04 percentage points to GDP. That’s about $6.4 billion — not much considering that QE3 purchases are currently $85 billion each month.
Reason 3: Foreigners are Unloading U.S. Treasuries
In June, foreign investors, believing that interest rates would continue to rise, unloaded U.S. Treasuries to the tune of $56 billion. For the same reason, U.S. commercial banks sold $20 billion. In that month, bond mutual funds and ETFs had net outflows of $25.5 billion. (July’s outflow from the mutual funds and ETFs was $15 billion.) <story_page_break>
Market participants have to be asking the question: What happens if the U.S. budget deficit rises back toward $1 trillion, as expected, and foreigners and the public have stopped buying?
The Fed is either going to have to allow rates to rise to the point where foreigners and the public will buy again, or the Fed will have to continue the QE program and become the major purchaser of the Treasury’s debt.
Those of us old enough remember that in the early ’80s, when then-Fed Chairman Paul Volcker allowed rates to rise, two recessions resulted (January 1980-July 1980, and July 1981-November 1982).
If we’ve reached this point, one must question the credibility of the Fed’s policies.
Reason 4: The Fed May Be Technically Insolvent
The Fed announced in March that it intended to hold all the securities on its balance sheet to maturity.
In an Aug. 1 post, Scott Minerd of Guggenheim Investments said that the duration of the Fed’s securities holdings is 6.5 years, and that the recent run-up in yields has wiped out “all of the unrealized gains that the Fed had accumulated since it began to implement quantitative easing in late 2008.”
The Fed has its own accounting principles and does not record mark-to-market losses. But, what if the Fed had to tighten policy by selling assets, i.e., traditional open market operations? It would have to record the losses.
With rates at current levels (as of Aug. 25), it is likely that the $55 billion of Fed equity capital (as of July 24), which is a mere 1.5% of assets, has already been wiped out on a mark-to-market basis.
My conclusion can be only that with a dysfunctional and confused Federal Open Market Committee, strategies that have failed to achieve stated objectives, a loss of confidence by major constituencies and a weak if not insolvent balance sheet, if the Fed were a publicly traded institution, Wall Street would savage its stock.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.