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There is all this talk about "tapering". Will the Federal Reserve taper or not taper, that's the question. To find the answer, we first need to take a look at the U.S. national debt, because there is an anomaly to be found.

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Chart 1: U.S. Public Debt

U.S. public debt has been growing at almost $200 billion a month at a constant pace. But since May 19, 2013, the debt ceiling has been stuck at $16.735 trillion and this ceiling has been in place for almost 2 months as chart 1 suggests. The Treasury says that they would be able to pay all the bills until October by enacting extraordinary measures from May 20 till August 2.

In all, the Treasury has the following measures available to it:

  • Suspend the investments of the Thrift Savings Plan G Fund (otherwise rolled over or reinvested daily, such investments totaled $130 billion in Treasury securities as of May 31, 2013);
  • Suspend investments of the Exchange Stabilization Fund (otherwise rolled over daily, such investments totaled $23 billion as of May 31, 2013);
  • Suspend the issuance of new securities to the Civil Service Retirement and Disability Fund and Postal Service Retiree Health Benefits Fund (totaling an estimated $79 billion on June 30, 2013, and about $2 billion each subsequent month);
  • Redeem early securities held by the Civil Service Retirement and Disability Fund and the Postal Service Retiree Health Benefits Fund equal in value to expected benefit payments (valued at about $6 billion per month);
  • Suspend the issuance of new State and Local Government Series (SLGS) securities and savings bonds (between $4 billion and $17 billion in SLGS securities and less than $1 billion in savings bonds are issued each month); and
  • Replace Treasury securities subject to the debt limit with debt issued by the Federal Financing Bank, which is not subject to the limit (up to $8 billion).

And due to higher tax revenues at the start of 2013, we see that interest payments on government debt weren't a problem. In fact, the interest payments as a percentage of tax revenue have been declining since 2013 (Chart 2).

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Chart 2: Interest payments as a % of tax revenue

Though, there is one parameter that was not anticipated and that is the effect of higher interest rates and higher mortgage rates.

First off, higher mortgage rates have an effect on the income stream of the Treasury from Fannie Mae and Freddie Mac. The Treasury depends on dividend payments from Fannie Mae and Freddie Mac in the amount of $60 billion. If mortgage rates go up substantially, these dividend payments could be in jeopardy. Fannie Mae's chief economist warns about these quickly rising mortgage rates:

The concern should be less about what the rates have risen to and more about the speed at which they are rising.

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Chart 3: Mortgage Rates Vs. Mortgage Applications (Zero Hedge)

Indeed, mortgage rates have risen from 3.5% to 4.5% in just a few months. If mortgage rates go up, lending becomes more difficult, so people stop applying for new mortgages (Chart 3).

When mortgage applications go down, home sales will go down. As suggested by the following chart, there is a correlation here between mortgage applications and pending home sales.

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Chart 4: Mortgage Applications Vs. Pending Home Sales

If mortgage rates keep rising at this pace, especially when the Federal Reserve is about to start "tapering" in September (right at the same time the debt ceiling will be breached), soon we will not see Fannie Mae and Freddie Mac contribute to the budget, but instead add to the budget deficit.

Additionally, we also see spiking U.S. Treasury yields. On Friday, July 6th, 2013, the 10 year U.S. Treasury yield hit a 2 year high of 2.7%.

Chart 5: 10 Year U.S. Treasury Yield

Bond guru Jeff Gundlach suggests that an increase of 100 basis points annually over the next five years would raise the interest payments on U.S. debt from $360 billion last year to $1.51 trillion. This will have an accelerating effect on the rising U.S. debt. That's why the probability of an act of "tapering" from the Federal Reserve in September is pretty low.

Third, rising yields on government bonds will have a negative impact on the balance sheet of the banks as they have a lot of these bonds in their portfolio. A quickly rising yield will devalue their assets in the short term. Some people say higher yields will give higher margins for the banks, but at this moment this doesn't compensate the losses on the bonds on their books. Eventually this will lead to lower revenue and lower tax income for the Treasury. We already see the effect of these rising interest rates. We have a slowing GDP, the U6 unemployment rate starts to edge upwards, the ISM purchasing manager index is starting to go into sub-50 territory which indicates a contraction in GDP growth. All of these signs are indicators of a slowing economy.

And finally, the fact is that the credibility of the Federal Reserve's solvency is at risk. Since 2013, the Federal Reserve has been buying Treasuries and mortgage backed securities, but these assets have lost at least 10% of its value ever since they bought it at the start of 2013. If the Federal Reserve were to ever unwind its balance sheet, these losses on the Treasuries and mortgage backed securities will become apparent. The higher the maturity, the higher the losses. To me, this is the main reason why tapering is out of the question, because it will question the Federal Reserve's solvency and tank the dollar with it.

It will be interesting to see the debt ceiling debate and the tapering of the Federal Reserve after the summer months. The key point to consider is, is there any chance that we will see a slowdown in the increasing balance sheet of the Federal Reserve at these surging bond yields and mortgage rates? I say no.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: U.S. Federal Reserve Tapering Is Out Of The Question