David R. Kotok
Chairman and Chief Investment Officer
More on the Fed’s Balance Sheet
July 18, 2010
Last week we wrote about the Federal Reserve’s balance sheet. Readers may find a graphic showing both the asset and liability sides of the Fed’s balance sheet at www.cumber.com . Check the bottom of the home page. The Bank of England and European Central Bank are shown as well.
The Fed now finds itself in the following position. Nearly one trillion dollars is deployed in the customary asset holdings of treasury securities; this asset is the counterweight to the liability of currency outstanding, which is of historic dimensions. We explained this in detail last week.
In addition, the Fed holds over a trillion dollars in federal-agency mortgage paper as an asset. It has over a trillion dollars in liabilities payable to banks for their excess reserve deposits. The Fed is earning an interest rate of about 4% on the assets and paying an interest rate of 0.25% on the reserve deposits. The Fed remits the “profit” to the US Treasury.
The Fed got into this position during the height of the financial crisis by launching the GSE mortgage-purchase program. At that time, Fannie and Freddie were failing. They had lost all credibility in the market. They ceased paying dividends on their preferred stock, even as it counted as “good” capital in banks. They were a mess. They still are and have survived only because of billions in infusions from the US Treasury, which has become their de facto guarantor.
Foreigners wanted to dump the GSE paper. Americans would not buy it. Either the Fed had to enter as the lender of last resort or the home-mortgage interest rate in the United States would have skyrocketed at the very time that housing prices were plummeting.
The Fed did what it had to do.
The Fed is now engaged in an internal debate over the question of additional stimulus. At the same time, it is gradually taking down its forecast of future growth and inflation. Our colleague Bob Eisenbeis has a special Commentary about the latest Fed forecasts. It may be helpful for readers to spend a few minutes looking at Bob’s piece. He has coupled the text with graphics to assist readers who want to delve into the very important quarterly process that the Bernanke Fed has introduced. Bob’s special essay is “Where Do We Stand?” at http://www.cumber.com/content/special/fomc071710.pdf. It is also available in the “Special Reports” section of our website, www.cumber.com.
We expect little new from Chairman Bernanke’s testimony next Wednesday. Congress may ask him about the Fed’s options if the economy weakens. He may talk about exit strategies. However, in the end we expect no substantive changes.
The Fed is on hold. If the economy weakens and the deflation risk rises, the Fed will add to stimulative programs and its balance sheet will grow further. There are many ways for it to do so. If inflation returns the Fed will tighten and its balance sheet will shrink as interest rates rise. The most likely outcome is that the Fed will do nothing. It will wait, watch, and worry. Worry is the key aspect for Fed watchers. Deflation is a more serous risk than inflation. That risk is rising every day.
This Fed posture is coupled with a slowly growing, non-inflationary economy. That is bullish for bonds and for stocks. We expect both asset classes to perform well over the next year or so.
Our stock market target remains closure of the Lehman Gap, that is, an S&P 500 index level of 1250-1300. S&P 500 earnings may approach $90 next year. At today’s price of twelve times those earnings, the market is cheap. Moreover, the third year of a presidential term is normally a very successful one for investors. This is more likely if the November elections create a deadlock between Congress and the White House.
Our bond strategy continues to focus on longer-duration tax-free and taxable (Build America) state and local government bonds with well-selected credit coverage. This Muni bond sector remains very cheap.
Finally, we have this note on the Leen’s Lodge annual economic and financial, professional invitational gathering (with incidental fishing and friendly wagering). We can advise that Bloomberg plans to cover the event this year with TV, radio, and other media. They intend to broadcast both radio and TV live from Leen’s Lodge on Friday, August 6.
David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com