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At the end of February 2012, the Federal Reserve held $1.66 Trillion of U.S. Treasury Securities. At the end of the same period, the top three foreign holders of U.S. Treasuries were China, Japan and Brazil with holdings of $1.2 Trillion, $1.1 Trillion and $225 Billion, respectively. This makes the Fed the largest holder of U.S. Treasury Securities. How did the Fed become the largest holder?

In late 2008, after the financial crisis took center stage, the Fed began to use all traditional monetary easing measures at its disposal. Once all traditional monetary easing measures were exhausted, the Fed chairman, Ben Bernanke took a lesson from Japan and started quantitative easing (QE) programs. Simply put, QE programs aim to lower interest rates by purchasing fixed income securities, as the demand for these securities goes up, the rates decline. In a sense, the Fed created a fictitious country, "Bernanke Island" (bear with me for the sake of the article) with a balance sheet larger than China and a population of one. The chart below shows the purchases of fixed income securities as a result of the QE programs. As you can see from the chart, the aggregate holdings of Bernanke Island are more than $2.5 Trillion, much larger than the $1.66 of U.S. Treasuries (blue portion of the chart).


(Click to enlarge)

Source: Data for chart retrieved from research.stlouisfed.org

As interest rates increase, a "plain vanilla" bond will fall in price. The opposite relationship holds when interest rates decrease. A good analogy is a teeter-totter with the price of the bond on one side and interest rates on the other side. As one side goes up, the other side must go down. The opposite holds true for a "short" bond funds' price, which moves in the same direction as interest rates. The chart below shows the level of interest rates since 1962 and vividly points out that rates are at their lowest level in history. In addition, you can see where rates have risen to in the past. The trillion dollar question is: How long will the Fed continue to hold treasuries and mortgage backed securities? After recent meetings, the Fed has reiterated the fact that they will continue to keep rates "exceptionally low" at least through late 2014. If you have the stomach for it and it fits within your investment horizon, you could begin to start shorting treasuries now for the long-term. However, some of the best bond investors have been caught trying to play this same card too early.

There is a range within the 10-year treasury rate that you can follow and make short-term trades using short treasury securities. As shown in the pop-out in the chart below, this range is between 1.80% and 2.30%. Trading within this band, on both the low and high of the ten year yield is difficult to achieve so you must narrow your trading band and use some leverage. To achieve the leverage needed to make the trade worthwhile, I look at ETF's such as the ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT). Since September of last year, the indicative strategy is to buy when the 10-year yield dips below 1.85% (green line) and sell when it rises back above 2.00% (red line). An extremely low interest rate environment, like the one we are in, creates a floor for this trade. As long as interest rates stay within this lower bound range (below 2.5%), the downside risk relative to the upside potential is miniscule.


(Click to enlarge)

Source: Data for chart retrieved from finance.yahoo.com

Bernanke took a lesson from Japan, who currently has a debt to GDP ratio exceeding 200%. Additionally, the recent European debt crisis has forced the European Central Bank to take similar actions. Currently, the Bank of Japan holds 8% of Japan Government Bonds (JGBs) while Japanese banks hold 39%. More importantly, the rate on the 10-year JGB has remained below 2% since 1998. Instead of the Japanese banks making loans to businesses and homeowners at a 4-6% interest rate, they are loading up their balance sheets with sub-2% JGB's. As a result, the loan-deposit ratio (how much money they are lending relative to how much clients are depositing in their accounts) across Japanese banks has declined from over 95% in 2000 to under 70% in 2011. This is more than likely a contributing factor to Japan's two-decade-long stagnant economy.

In a speech on December 5th, 1996, then chairman of the Federal Reserve, Alan Greenspan was quoted saying "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?" He added that "We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability." Unfortunately, Japan's economy has only moved sideways since Greenspan's 1996 speech. However, Ben Bernanke has stated numerous times that we are not in the same position as Japan and we will not repeat the mistakes made by Japan. Time will tell if the Fed will be able to unwind its holdings without impairing the real economy or if we will fall into a Japanese-like economy.

Disclosure: I am long TBT.

Source: Bernanke Island