The Federal Reserve Balance Sheet Points To A Continuation Of Low Interest Rates

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 |  Includes: DTYL, TLH, TLT
by: Katchum

I have been talking a lot about the Federal Reserve balance sheet. But what is it composed of? And how did it evolve higher?

Chart 1 gives the composition of the Federal Reserve balance sheet. You can see that QE1 and QE2 were mainly bond purchases (light brown area). QE3 should be another round of bond purchases and should expand the light brown area again.

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Chart 1: Federal Reserve Balance Sheet

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Second, the spike in 2008 was mainly lending to financial institutions at the time of the banking collapse. This lending has been paid off in 2010.

But the most interesting part is the mortgage-backed securities area in dark brown. In that period, Congress passed the Emergency Economic Stabilization Act of 2008, which authorized the Treasury to purchase mortgage-backed securities. As a consequence, the dark brown area increased in size at the same time when lending to financials decreased. That means that the Federal Reserve has bought approximately $US 1 trillion of mortgage-backed securities in an attempt to support the housing market. It didn't do much to the housing market. New home sales and housing starts were flat (Chart 2), but the housing market index improved a bit though.

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Chart 2: Housing Starts
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The amount of mortgage-backed securities on the Federal Reserve's balance sheet explains why the Federal Reserve wants to keep interest rates low for an unlimited amount of time. When interest rates go up, mortgage-backed securities tend to act like bonds. Higher interest rates will make the mortgage-backed securities go down in price. Lower interest rates will make the mortgage-backed securities go up in price. There is a little difference though called "negative convexity". This means that compared to bonds, mortgage-backed securities will go up less in price (during periods of declining interest rates) and they will go down more in price (during periods of rising interest rates).

Let me explain this important term of "convexity" in more detail (Chart3):
Bonds have positive convexity. This means that the price of the bond flattens out with rising yield. The price will drop less with rising interest rates. On the other hand, mortgage-backed securities have negative convexity. This means that the price of the mortgage-backed security steepens to the downside with rising yield. The price of these mortgage-backed securities will drop much faster with rising interest rates. Interesting to note is that longer term bonds will decrease faster in price with rising yields.

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Chart 3: Convexity

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So the Federal Reserve wants to make absolutely sure that interest rates in the market stay low, otherwise their mortgage-backed securities would plunge in price due to negative convexity. The second reason why the Federal Reserve doesn't want interest rates to rise is because they own a lot of long term treasury paper. And I already discussed above that long-term treasury paper will drop much faster in value with rising yields as compared to short-term treasury paper.

The only caveat, though, is that the Federal Reserve doesn't have the means anymore to buy long term bonds to keep interest rates low. Operation Twist II is estimated to end before the end of the year. This means that the Federal Reserve cannot sell any short term bonds to buy long-term bonds by then. The only solution is to print money to keep interest rates low, and this will debase the U.S. dollar.

The latest news confirms this thesis as Bloomberg reported on 11 July 2012 that a few FOMC members said more stimulus is probably needed.

Conclusion: you can be sure of it that interest rates on government bonds (NYSEARCA:TLT), (NYSEARCA:TLH), (NASDAQ:DTYL) will stay low for a very long time by just looking at the Federal Reserve balance sheet. But the consequence is a devalued U.S. dollar.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.