In seeking to save the economy from the consequences of one economic bubble, the top political and economic leadership of the country has created another, more dangerous one—and hardly anyone is talking about it.
In fact, some of the charlatans who pose as economic commentators are assuring us that the looming disaster is actually good news. Yes, I’m talking about Paul Krugman, who recently offered this amazing assurance to his readers.
Far from fleeing U.S. debt, investors have continued to pile in, driving interest rates to historical lows…. [W]e have our own currency—and almost all of our debt, both private and public, is denominated in dollars. So our government, unlike the Greek government, literally can’t run out of money. After all, it can print the stuff.
Leave aside for the moment the blithe assurance that we can just print as much money as we like. Look instead to that assurance about interest rates being at historical lows. This in itself is a whole new crisis.
By artificially depressing interest rates to levels never seen before, the Federal Reserve has set us up for disaster when they bounce back. At some point, rates are going to rebound from a current average of about 2% to the historical average of 5%—or higher, given all of that money-printing.
And what happens then? Consider the impact on bond prices.
Here you need to know a little basic bond math, which is simple and straightforward and virtually unknown to the general public. Let’s say that you buy a $100 bond paying 5% interest, or $5 per year. Then the prevailing rate of interest goes down by half, to 2.5%. What this means is that your $5 per year in interest is equivalent to the interest paid on $200 of bonds at the going rate—which implies (all other things being equal) that you can sell your $100 bond for $200, a huge capital gain on your investment. But what will kill you is what happens when things go the other way. If you buy a $100 bond paying $2.50 per year in interest, a 2.5% rate, and then rates bounce back to 5%, who is going to want to buy your bond for $100 when they can buy a new one that pays twice as much. So you will have to compensate by selling your bond for half as much. Your $2.50 in interest will equal a 5% rate—on a price of $50.
This is basically what is about to happen to trillions of dollars of bond investments. By artificially depressing interest rates, the Fed has artificially increased the price of bonds, creating a whole new bubble that is ready to burst.
Jonathan Trugman puts some dollar figures on the potential damage.
[R]ates would not have to go through the roof to take out billions in principal for investors, most of whom are in bonds because they are nearing retirement.
“If the 10-year [bond] goes up 100 basis points, that could mean more than $35 billion is lost,” says one bond trader.
One hundred basis points is just a 1 percent increase, which would put the 10-year at about 2.6 percent. The average rate of return over the last decade is roughly 4 percent, which, if we return to that yield, could put principal losses close to $500 billion, says a bond manager.
Now consider that all of this applies, not just to retiring Baby Boomers who have been told that bonds are a safe investment, but also to the Federal Reserve itself, which is one of the world’s biggest holders of US government bonds. As Alex Pollock points out:
The combined balance sheet of the Federal Reserve has $2.9 trillion in assets and $55 billion in equity, for leverage of a heady 52 times and a capital ratio of a paltry 1.9 percent. On top of this high leverage and little capital, the Fed runs massive interest rate risk, with investments in long-term mortgage-backed securities (MBS) of over $900 billion and longer-term Treasuries of $1.65 trillion….
The Fed has announced it will be adding $40 billion a month to its $900 billion in MBS, so it’s fair to consider that in a few months it will own $1 trillion in these mortgage securities. A reasonable estimate is that a 2 percent increase in interest rates would reduce the value of long-term fixed rate MBS by about 15 percent. On $1 trillion of mortgages, this would be a hit to the Fed’s market value of about $150 billion.
The $1.65 trillion in longer-term Treasuries probably has an average maturity of at least five years. A reasonable estimate of market value loss on this position for a 2 percent increase in interest rates might be 10 percent, or $165 billion.
The total loss to the economic value of the Fed’s aggregate balance sheet would therefore be about $315 billion, compared to total capital of $55 billion. The Fed is thus vulnerable under this reasonable scenario to market value loss of over 5-1/2 times its total capital.
If this were a private bank, we would describe it as teetering on the brink of insolvency. But being a government-sponsored entity means never having to say you’re sorry, so it’s less clear that the Fed will really suffer any consequences for going broke. We’re the ones who are going to suffer the consequences.
What is clear is that the Fed’s policy of trying to stimulate the economy by driving down interest rates as close to zero as possible has put the entire economy into new and uncharted territory of interest-rate risk. It is the usual pattern of government intervention: in trying to push off the consequences of one crisis, they create another crisis. And then everyone wonders why we go five years—or ten—of constant turmoil and anemic growth.