La Fed Aux Folles

by: Bachar Samawi

I remember when I was about 13 years old, and while visiting Paris with my family, my mother decided to take me to see the French play "La Cage Aux Folles (The Nuthouse)." The truth is that at that time, I did not truly understand it, as I was simply too young for some of its concepts which I had never been exposed to before. Nevertheless, as everyone else was having a good time and laughing, it did not mean I also could not have a good time. Well, I laughed along and certainly enjoyed myself; as a 13 year old, I found it colorful, funny, and in a simple word, crazy.

This memory was brought back to life when the Fed announced its latest quantitative easing program on September 13. In a sense, the latest program is colorful, funny, and in a simple word, crazy. Everyone seems to be cheering as the markets record new highs. However, something is different this time around; I simply cannot convince myself to go along with the crowd. Throughout my 25-year trading experience, I learned to respect the phrases "the trend is your friend," and "never fight the Fed," but the current environment has simply become too crazy for my taste.

There was a time when the general wisdom was that if economic indicators were good, that boded well for the economy and for the markets. Now, we are told the opposite is true; if economic indicators are bad, then that is good for the markets. Why? Because bad economic indicators will ensure further quantitative easing will continue, and printing money is good for the markets. I certainly will laugh, but I will not go along.

Following the quantitative easing announcement, Bernanke made a small speech and proceeded to answer questions. In such forum, Bernanke justified the Fed's action by claiming that such money printing (although he did not call it as such) will help increase asset values, such as housing and stocks, which will in turn increase the public confidence to consume, hence leading to increased growth and hiring. As for the risk of inflation, well he simply does not see any inflationary pressures at this time, and if matters were to reverse, the Fed would then reverse its actions and start draining money from the system by selling securities.

In reality, there are two fallacies that Bernanke simply chose to set aside.

First, his assumption that the Fed's purchase of mortgage backed securities will lead to increased mortgage lending is mostly flawed. If mortgage rates drop from say 10% to 5%, then it is certainly the case that mortgage lending will increase as the effect of such move will cause a substantial drop in homeowners' monthly installment payments. However, the current 30-year mortgage rate is already as low as about 3.5%, while the 15-year mortgage rate is about 2.9%. Any further drop in such mortgage rates, if any, is unlikely to be much of an incentive for homeowners. Furthermore, a drop in mortgage rates is unlikely to change the credit risk and rating of potential homeowners. Potential home buyers who had been turned down by their bankers for credit reasons are unlikely to be approved in a slightly lower interest rate environment.

Second, the Fed has totally ignored potential capital losses it could incur on its security purchases. Bernanke has simply told the public that if inflation starts creeping higher, then he would simply reverse action and drain liquidity by selling back those securities. What he hasn't told the public is that he would incur substantial losses on such sales, and he would never be able to drain the same amount he pumped into the system.

If inflation starts creeping higher and interest rates move higher, then the Fed's holdings of mortgage backed securities will suffer on two fronts: first, as yields rise, their price will fall due to higher yields of newly issued mortgage backed securities. Second, due to convexity, as yields rise, mortgage prepayments will drop, causing the duration of such mortgage backed securities to increase, hence resulting in additional drop in the price of such securities.

Running a few simulation models, and depending on assumptions for inflation, interest rates and velocity of their change, one can easily conclude that in an inflationary environment, the Fed could lose anywhere between 20% and 60% on its holdings. In other words, in an inflationary environment, it would be virtually impossible for the Fed to drain all the money it has printed, as it will suffer capital losses on the sale of its securities. Given that the Fed's quantitative easing can reach well over $3 trillion, then it is also possible that its capital losses can also approach and possibly exceed $500 billion to $1 trillion.

Well, Bernanke cares about employment. He wants a lower unemployment rate, and the "end" justifies the "means." Unfortunately, the "end," which he seems to take for granted through his money printing scheme, is highly hypothetical. As for the "means," he has presented it selectively, by claiming the action is reversible, without addressing the potential for capital losses.

Why exactly do I find this crazy? Well, Bernanke seems to think that the government needs to be fiscally responsible. The fiscal cliff facing the nation needs to be addressed and the government's budget deficit needs to be addressed and brought under control. So how exactly does he lead by example? By printing money, and risking the accumulation of sizable capital losses by the Fed. If that is not crazy, then I do not know what is.

As I said earlier, I will laugh, but I will not go along. The Fed's program has simply become too dangerous and can cause the markets to witness periods of volatility and substantial losses. As long as earnings remain subdued, the market's downside risk is simply too great. Investors are better served by being selective and restricting their holdings to companies actually generating solid earnings and meeting their targets, as opposed to "potential Bernanke driven trickle down".

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.