July 31, 2013 | By Scott Minerd
As markets begin to digest the outcome of the Federal Open Market Committee’s latest policy setting meeting, one of the less-discussed Fed-related risks is the drop in the value of its portfolio due to rising interest rates. Since 2008, the assets on the Fed’s balance sheet have ballooned to $3.5 trillion from $480 billion, and its portfolio duration has extended to about 6.5 years from 2.5 years. The Fed has said it intends to hold these assets until maturity. However, should conditions necessitate monetary tightening by engaging in asset sales – for example, if inflation rises more suddenly than expected – the Fed would be forced to sell assets, spurring further increases in bond yields. Although the Fed does not value its portfolio on a mark-to-market basis, the spike in interest rates over the second quarter has already reduced the market value of the Fed’s portfolio by about $192 billion, wiping out the entirety of the past year’s unrealized portfolio gains. Higher rates would continue to reduce the value of liquid assets available for sale, thus eroding the Fed’s capital cushion. Given that the Fed’s capital currently sits at only $55 billion, a continued increase in interest rates could potentially erase the Fed’s capital base. This could impair the Fed's ability to sell assets and protect the purchasing power of the dollar, which in turn could reduce the value of Treasuries and push interest rates even higher.
The Fed’s intention to hold assets on its balance sheet to maturity may partly be attributable to the potential losses that could come from such asset sales. Our estimate shows that the spike in bond yields since the first quarter of this year has caused a mark-to-market loss of $192 billion on the Fed’s holding assets, equivalent to approximately all of the unrealized gains that the Fed had accumulated since it began to implement quantitative easing in late 2008. Although in keeping with their own accounting principles the Fed does not record mark-to-market losses, a continued increase in bond yields would incur actual losses should the central bank decide to sell assets.
Source: Federal Reserve Bank of New York, Bloomberg, Guggenheim Investments’ estimate. Data as of 7/31/2013. *Note: We project the average duration of the portfolio to be approximately 6.5 years based on the presentation from Richard Fisher, President of Federal Reserve Bank of Dallas, at National Association for Business Economics in May 2013. We also assume the Fed’s asset purchases since Q1 have no unrealized gains.
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