What Happens to Self-Funding Early Pay Programs When the Fed Raises Rates? Part II

Transiting-Inconjuncts1

Yesterday I wrote about the Fed’s intention to raise interest rates based on two dependencies – labor market conditions and the core PCE inflation rate.

Why this Fed is so challenged to raise rates, even by 25 bps, can come down to understanding its balance sheet. Since 2008, the Fed’s balance sheet has mushroomed. Its assets, which include a mixture of government bonds, Treasury notes, and mortgage-backed securities, were bought to keep long term rates low as part of QE 1, 2 and 3. The Fed needed to issue paper or dollars to buy those assets (i.e., a corresponding liability).

Here lies the rub. The Fed's balance sheet is totally weighted on the asset side to long term duration assets, i.e., 10- and 30-year government bonds and mortgage-backed securities and other medium-term notes and Treasuries. However, its deposits are all short term bank deposits.

Dickson Buchanan of SchiffGold Precious Metals helps with the math:

"The yield on a 10-year bond is 2%. This is the interest the Fed receives on its loans, which are its long-term assets. On the other side, the Fed owes no more than 0.25% on its short-term deposits, which are its short-term liabilities. That’s a year-over-year profit of 1.75%. It has bought roughly $2.8 trillion of long-term debt, so that equates to approximately $49 billion in yearly profits. Not bad – as long as rates are kept low.

But the Fed wants to raise rates (or so it claims). The market is also expecting a rate hike. What happens to this game of monetary musical chairs if the Fed does deliver the higher interest rates it’s been promising?"

Any rate rise would be devastating to the Fed's portfolio, as even a 1% hike would effectively reduce the market value of its long term asset portfolio – OK, you can argue they will hold to maturity – but doing mark to market, the Fed's balance sheet looks a lot worse.

So given its intention of raising rates based on the 2 conditions, it remains to be seen how this all works. We are in new territory. Or as my mother used to say, it’s a real pickle.

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