By
Scott
Minerd
:
In Goethe's 1831 drama
Faust
, the devil persuades a bankrupt emperor to print and spend vast
quantities of paper money as a short-term fix for his country's
fiscal problems. As a consequence, the empire ultimately unravels
and descends into chaos. Today, governments that have relied upon
quantitative easing (QE) instead of undertaking necessary
structural reforms have arguably entered into the grandest Faustian
bargain in financial history.
As a result of multi-trillion dollar quantitative easing
programs, central banks around the world have compromised their
ability to control the money supply, making them vulnerable to
runaway inflation. When interest rates rise, the market value of
central bank assets could fall below the face value of their
liabilities, potentially rendering the banks incapable of
protecting the stability and purchasing power of their
currencies.
In The Beginning, There Was Gold
To better understand the potential consequences of quantitative
easing, it is useful to review the historical evolution of central
banking. Early central banks acted as clearing houses for gold.
Individuals and trading companies placed their bullion on deposit
at a central bank and received a claim that could be redeemed upon
demand. The system's strength was largely derived from its
simplicity. This innovation had a profound effect on global trade.
In the British Empire, for example, it meant a gold-backed pound
note from London could be used for commercial purposes in
Bombay.
Today, the gold standard no longer exists and, for the first
time, the entire global monetary system is built on a foundation of
fiat currencies. This monetary paradigm works because of an abiding
faith that paper money will be accepted as a medium of exchange and
remain a store of value. At the core of this system is the
presumption that central banks, as the issuers of paper money, have
enough assets that can be readily sold in the event that their
currencies' value begins to fall and the money supply needs to be
reduced. When confidence in a central bank's ability to reduce its
money supply in a sufficient amount to maintain its currency's
purchasing power is drawn into question, there is a risk of a
currency crisis or even hyperinflation.
(click images to enlarge)
While Europe has had central banking since the 17th century, the
United States did not have a central bank until the beginning of
the 20th century. As a direct result of the panic of 1907, the
Progressive political movement created the Federal Reserve System
in 1913. Under the newly created Federal Reserve, the definition of
eligible central bank reserve assets was extended beyond gold to
include short-term bills of trade such as bankers' acceptances. By
expanding the definition of reserve assets, the Federal Reserve had
the ability to temporarily increase the money supply in excess of
the amount of its gold reserves, to provide elasticity to credit
markets. This incremental flexibility in money creation was
designed to reduce the risk of panics that had plagued the U.S.
through most of the 19th century under the gold standard.
During the Great Depression of the 1930s, the Federal Reserve
sought greater flexibility and leverage. In 1934, the Federal
Reserve noteholders' right to convert paper to gold on demand was
unexpectedly revoked, and the U.S. government seized all of the
citizenry's gold holdings. Subsequently, the Treasury arbitrarily
re-valued the price of gold from $20.70 to $35 per ounce.
Nevertheless, the presumption remained that every U.S. dollar was
"as good as gold" because the Federal Reserve continued to hold
bullion as its primary reserve asset.
A Dangerous Game
In 1935, the Federal Reserve was also granted "temporary"
emergency powers allowing it to begin using Treasury securities, or
government debt, as a reserve asset. The problem with Treasury
securities as a reserve asset is that, unlike gold, they are
affected by changes in the level of interest rates. The impact of
interest rates on the value of these securities is commonly
measured in units of time and price sensitivity referred to as
duration.
The higher the duration of an asset, the more sensitive its
price is to changes in interest rates. For example, an upward move
in interest rates will cause the value of a bond with a duration of
10 years to fall by 10 times the value of a bond with a duration of
one year.
As the Federal Reserve's holdings of Treasury securities
increased relative to its gold holdings, its portfolio took on
greater duration risk. For the first time, the potential existed
that rising interest rates could cause the market value of the
Federal Reserve's assets to fall below the face value of its
liabilities (Federal Reserve notes). This was not a concern under
the tautological gold-backed system because the value of a central
bank's outstanding notes was directly tied to the amount of gold in
its vaults.
The way to minimize the risk of a meaningful decline in the
value of balance sheet capital resulting from a rise in interest
rates was for central banks to maintain a relatively low
debt-to-equity ratio while keeping a relatively short interest rate
duration on its assets. By maintaining this discipline, the Federal
Reserve was virtually assured of having enough liquid assets at
market levels to repurchase dollars without incurring large losses
on its portfolio.
Quantitative Quagmire
From the 1930s until the early part of the current century, the
Federal Reserve was able to engage in relatively effective monetary
policy. In 2008, just prior to the first of two rounds of
quantitative easing, the Federal Reserve had $41 billion in capital
and roughly $872 billion in liabilities, resulting in a
debt-to-equity ratio of roughly 21-to-1. The Federal Reserve's
asset portfolio included $480 billion in Treasury securities with
an average duration of about 2.5 years. Therefore, a 100 basis
point increase in interest rates would have caused the value of its
portfolio to fall by 2.5%, or $12 billion. A loss of that magnitude
would have been severe, but not devastating.
Beginning in 2008, the monetary orthodoxy of the previous 95
years quickly disappeared. By 2011, the Federal Reserve's portfolio
consisted of more than $2.6 trillion in Treasury and agency
securities, mortgage bonds, and other obligations. This resulted in
an increase in the central bank's debt-to-equity ratio to roughly
51-to-1. Under Operation Twist, the Federal Reserve swapped its
short-term Treasury securities holdings for longer-term ones in an
attempt to induce borrowing and growth in the economy. This caused
an extension of the duration of the Federal Reserve's portfolio to
more than eight years.
Now, a 100 basis-point increase in interest rates would cause
the market value of the Federal Reserve's assets to fall by about
8%, or approximately $200 billion, which would leave the Federal
Reserve with a capital deficit of $150 billion, rendering it
insolvent under Generally Accepted Accounting Principles (GAAP).
Although this may not happen in the immediate future, if interest
rates rose five percentage points, the Federal Reserve could lose
more than a trillion dollars from its fixed income portfolio.
Staring Into A Monetary Abyss
Unlikely as it seems in a world of zero-bound interest rates,
someday, as the economy continues to expand, the demand for credit
will increase to the point that interest rates will begin to rise.
In time, significantly stronger growth will create economic
bottlenecks, placing upward pressure on prices. At that time, the
Federal Reserve would be expected to restrain credit growth by
selling securities, resulting in a further increase in interest
rates.
As interest rates rise, the market value of the Federal
Reserve's assets will fall. It could then become apparent that the
face value of the Federal Reserve's obligations had become greater
than the market value of its assets. This could leave the Federal
Reserve without enough liquid assets to sell to protect the
purchasing power of the dollar, resulting in a downward spiral in
its value.
If the dollar weakens relative to other currencies, its use as a
reserve currency, and the safety of U.S. Treasuries, could falter.
Given the United States' dependence on foreign capital to finance
its large fiscal deficits, a reduction in foreign flows could cause
Treasury securities to lose a significant amount of value. The
Federal Reserve could then find itself having to support the price
of the country's debt by becoming the buyer of last resort for
Treasury securities. This scenario would closely resemble events
unfolding in the periphery of Europe today. By printing increasing
amounts of money to finance the national debt, the Federal Reserve
would lose control of its ability to manage the money supply,
leaving the government hostage to its printing press.
Investment Implications
To hedge against deterioration in the dollar's purchasing power,
investors have already begun migrating toward hard assets such as
gold, commercial real estate, artwork, collectibles, and rare
consumer products like fine wines. Such diversification may have
significant barriers to entry, however, considering the risks built
into financial assets, long-term investment portfolios should be at
least partially composed of tangible assets.
Other areas that are likely to perform well in the immediate
term due to effects of quantitative easing are credit-related
instruments, including bank-loans and asset-backed securities. High
yield debt should perform well because abundant liquidity means
default rates will remain low. Additionally, the ongoing balance
sheet expansion by the European Central Bank means European equity
prices are likely to outperform U.S. equities over the coming
years.
Long-duration, fixed-rate assets such as government bonds are
likely to underperform. Given the primacy of Treasury securities in
the Federal Reserve's current yield curve management program,
Treasury bonds will come under the greatest pressure once the
Federal Reserve ends QE. This asset class' yields have fallen by
over 1100 basis points in the past three decades.
While no one knows if we have reached the bottom for Treasury
rates, staying in the market for the final 50 or 60 basis points
appears imprudent. As Jim Grant has noted, investors' perception of
U.S. Treasuries -- and most sovereign debt -- is shifting from
representing risk-free return to "return-free risk." Now is a
better time to sell Treasury securities than to buy them, and for
the stout of heart, this is an opportunity to set short positions
in the asset class.
An Uncertain Future
Half a year before the centennial of central banking in the
U.S., neither policymakers nor investors have much to celebrate. By
abandoning monetary orthodoxy and pursuing large-scale asset
purchases, global central banks have increased the risk of
inflation and compromised their ability to stamp it out.
Inordinately higher leverage ratios and the extension of central
bank portfolio duration means governments now face the potential
for central bank solvency crises. It is too early to predict
exactly how this Faustian bargain will play out; but, with each
additional paper note that rolls off the printing press or gets
conjured up in the ether, the likelihood of a happy ending becomes
increasingly evanescent.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it (other than from Seeking Alpha). I
have no business relationship with any company whose stock is
mentioned in this article.
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