Jim Rickards--"The Fed Can't Have it Both Ways"

[Celebration]

http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2010/11/5_Jim_Rickards_-_Fed_May_Go_Bankrupt.html

How risky is the Fed’s program of bond purchases? Very. For those who are not bond traders, here are a few quick pointers. First off, intermediate term securities are more volatile than short-term securities. The Fed traditionally purchases Treasury bills of one-year or less in maturity. Those bills are not volatile at all and don’t move much in price when interest rates change. So, mark-to-market losses are never that great. But 10-year notes are highly volatile and losses can be huge in response to even modest increases in interest rates. Secondly, with the Fed composing such a large part of the Treasury market, liquidity will decrease as fewer participants buy and sell each day due to the Fed’s dominant role. This means bid/offer spreads will widen making it very costly for the Fed to unload their position if they want to. If the Fed is selling, who on earth wants to buy? Finally, there is a concept called “DVO1” which is market jargon for the “dollar value of 1 basis point”. This is a measure of how much a bond goes down in price in response to a 1 basis point increase in interest rates. It happens that DVO1 is greater as interest rates are lower. In other words, the decline in price of a bond in response to a 1 basis point increase in rates is greater when rates are at 1% than if they are at 5%. This element of volatility is independent of the fact that longer maturities are more volatile, so having longer maturities and a low-rate environment is like soaking C4 plastic explosives in nitroglycerine.

When critics raise the issue of mark-to market losses, the Fed has a simple answer, which is that they will hold to maturity. The Fed does not have to mark to market; they can simply hold the assets to maturity and collect the full proceeds from the Treasury or other issuers. Just ignore for the moment the fact that some of the junkier assets and mortgages will not pay off, ever. That’s years away; for now, let’s just give the Fed the benefit of the doubt and say that mark-to-market losses don’t matter because they don’t have to sell.

Critics also raise the issue that this much money printing will result in inflation at best and maybe hyperinflation if velocity takes off due to behavioral shifts. The Fed is also very reassuring on this point. They say not to worry because at the first signs of sustained and rising inflation they will reverse course and reduce the money supply by selling bonds and nip inflation in the bud. But also note that the world in which the Fed wants to sell the bonds is also a world of rising inflation and therefore rising interest rates. This is the world of huge mark to market losses on the bonds themselves.

The Fed is saying don’t worry about mark to market losses because we will hold the bonds. The Fed is saying don’t worry about inflation because we will sell the bonds. Both of those statements cannot be true at the same time. You can hold bonds and you can sell bonds but you can’t do both at once. You will want to sell when rates are going up but that’s when losses will be the greatest. So the time when you most want to sell is the time when you will most want to hold. The Fed may say they can finesse this by selling shorter maturities only to reduce money supply and holding onto longer maturities. But that just further degrades the quality of the Fed’s balance sheet and turns it into a one-way roach motel for highly volatile and junk assets.

Definitely right on this point!

[bemildred]

1. Trust me.