Global CIO Commentary 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.
Mark-to-Market Loss on Fed’s Assets
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.
CUMULATIVE UNREALIZED GAINS IN THE FEDERAL RESERVE’S PORTFOLIO*
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.
Economic Data Releases
Second Quarter GDP Surprises
- Second quarter GDP rose a better-than-expected 1.7% annualized rate, while the first quarter was revised down to 1.1%. The second quarter gains were led by increased inventories, while real consumer spending was up 1.8%.
- The S&P/Case-Shiller 20-City Home Price Index grew 12.2% annually in May, the best since March 2006.
- Pending home sales decreased 0.4% in June, a smaller-than-forecast decline.
- Initial jobless claims rose slightly to 343,000 for the week ended July 20th, with the four-week moving average ticking down.
- Durable goods orders jumped 4.2% in June, but excluding transportation were flat. Non-defense capital goods orders rose for a fourth consecutive month, up 0.7%.
- University of Michigan consumer confidence advanced to 85.1 in July from 84.1 at the end of June, the highest level in six years.
- The Conference Board consumer confidence index fell in July to 80.3, the first decrease in four months.
Euro Zone Confidence Continues to Climb, Inflation Returns in Japan
- Economic confidence in the euro zone increased to 92.5 in July, the third straight gain and the highest since April 2012.
- The euro zone unemployment rate was unchanged in June at 12.1%.
- The German IFO Business Climate Index rose to a four-month high in July of 106.2.
- German retail sales dropped 1.5% in June, the most since January.
- French consumer confidence increased to 82 in July from a revised 79 in June, the largest increase for the index since March 2012.
- Spain’s GDP shrank 0.1% in the second quarter from a quarter earlier, the slowest pace of contraction since 2011.
- The U.K.’s GDP grew 0.6% in the second quarter, marking two consecutive quarters of growth.
- In June, Japanese consumer prices rose on an annual basis for the first time in over one year, up 0.2%.
- Japanese retail sales unexpectedly fell in June, down 0.2% after rising the previous two months.
- Japan’s industrial production fell more than expected in June, down 3.3% from a month earlier, and was the worst month since March 2011.
Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLC ("Guggenheim"). Guggenheim Funds Distributors, LLC is an affiliate of Guggenheim.
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