Over the last few months, there has been considerable talk about the “taper,” referring to the end of the Federal Reserve’s purchasing program known euphemistically as “quantitative easing.”
Under QE, as it is generally referred to, the Federal Reserve has been engaging in purchasing of assets (particularly United States Treasuries and mortgage-backed securities) in an effort to stimulate the economy by permitting more spending. The Fed also hoped to provide stimulus to the housing market by artificially depressing interest rates.
The purpose of Quantitative Easing is to provide money to the federal government by buying its Treasury debt (which was increasing at a very fast rate from late-2008 to date) to avoid the flooding of the markets with unwanted Treasury Bonds. If there are too many bonds and no buyers, the price of the bonds drops and interest rates rise. This will negatively impact everything from mortgage rates to other forms of debt, which link their rates to the yield of US Treasuries.
As a reminder, interest rates on bonds and bond prices move inversely. Thus, if the price of the bond increases (reflecting higher demand for “safe” assets), the interest rate will drop. If the demand decreases, the effective interest rate on the bond will rise.
Here’s a very brief history of Quantitative Easing:
QE began in the depths of the 2008 financial crisis with the Federal Reserve buying mortgage-backed securities to provide liquidity to banks and to keep the “bad” assets off of the banks’ books for a period of time. A total of $1.25 trillion in mortgage-backed securities were purchased during the first round of Quantitative Easing that ran from November 2008 to early 2010.
In November 2010, the Fed began QE 2, which was a second round of asset purchases. QE 2 lasted until June 2011 and resulted in the Fed purchasing another $600 billion in assets along with a reinvestment of $300 billion from the previous QE. This time it was longer-dated United States Treasuries, rather than just mortgage backed securities.
After the second round of QE, it seemed like the Federal Reserve was wary of inflationary pressures from printing a few trillion dollars. So, in the summer of 2011, the Fed introduced “Operation Twist:” the Fed purchased longer-dated United States Treasuries and sold shorter-dated ones. For example, the Fed would buy a 30-year “Long Bond,” but sell one of the 2-year US Treasury Notes that it had in its portfolio. In other words, the Fed was not printing money per se, but rather trying to lower the yield of the 30 Year Treasury by artificially increasing the demand for such instruments.
Since Operation Twist concluded in 2012, the Fed has been purchasing assets in what is euphemistically called “QEternity” by some (myself included), because the program had no official end date. The Fed has been buying $80 billion in securities on a monthlybasis since September 2012 and continues to do so until it officially “tapers” QE. Some predict it will happen this fall or early next year.
Since early 2008, the Federal Reserve’s balance sheet has skyrocketed from having $800 billion on the books to nearly $3.7 trillion today.
The concern is that the Fed’s balance sheet needs to be “unwound,” meaning that the Fed needs to sell the bonds that it bought in order to end to Quantitative Easing. By doing so, the fear is that investors will continue to dump Treasury instruments, thus causing prices on bonds to drop and interest rates to continue to rise.
Since investors have begun really pondering the effects of the “taper,” the yield on the 10 year Treasury has increased from roughly 1.55% to over 2.8%. That’s quite an increase from the three month period from May, 2013 to August, 2013. The 30 year bond has increased from 2.8% to 3.6% over the last year.
Many folks talk about hyperinflation as a potential side effect of Quantitative Easing, thus they want the Fed to end QE as soon as possible so as not to stoke inflationary pressures. Personally — though it is undeniable that the costs of things that reflect inflationary pressures continue to increase or remain elevated (food, fuel, education, health care) — I don’t think we are anywhere near a hyperinflationary event like the Weimar Republic (post-World War I Germany).
The much bigger concern for me is the funding of our obscene national debt. As you likely know, America currently has approximately $16.7 trillion of debt (not including unfunded liabilities such as Obamacare, Medicare, and Social Security-care). The current interest on debt is $223 billion. Think about that: every year, in order to pay for the debt that we have already incurred, we need to spend $223 billion. That represents over 7% of the projected revenue in the 2014 Federal Budget and almost a third of the projected 2014 budget deficit.
Does that seem small to you?
The problem is that the debt has been financed by artificially low interest rates. As interests rates go up, the cost of borrowing also goes up. The CBO estimates that the 10 Year note could increase to as high as 5.2% in 10 years, which would cause the interest on the projected national debt to jump to over $820 billion dollars. That’s dangerously close to a trillion dollars just in interest. And we all know how good government predictions are, right? They only missed the cost of Obamacare by half.
In other words, while I am all for the Fed leaving the market alone with respect to the manipulation of interest rates, I am deeply concerned about the impact of the taper on interest rates.
Shorter: we need to cut spending before we hit a trillion dollars of interest a year. Spending a third of your money on financing old debt (let alone newly acquired debt) is a recipe for disaster — and bankruptcy.
The Fed helped us get into this mess by permitting our reckless politicians to be able to borrow money at low rates for too long. If we are not careful, we will reap what we sow.
As always, free markets are better markets.
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I expect a relatively calm week going into the Labor Day weekend. We will still have initial jobless claims on Thursday, as well as earnings reporting this week. Durable goods and housing data will be released in the early part of the week as well.
Have a great week!