By Alan Gula
The Federal Reserve holds $4.4 trillion worth of assets on its balance sheet.
Of this total, $2.3 trillion is in U.S. Treasury notes and bonds. These Treasuries are parked in the System Open Market Account, which contains assets acquired via open market operations - including quantitative easing (QE).
I bring this up in response to a Bloomberg article penned by Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis. In the article, titled "The World Needs More U.S. Government Debt," Kocherlakota claims the U.S. government isn't issuing enough bonds to satisfy household and corporate demand.
Well, if there aren't enough Treasuries for private investors, perhaps the Fed should sell off some of its own stockpile of Treasuries. Don't you think? Of course, this would effectively function as reverse QE, which would cause financial asset prices to fall. In other words, the Fed won't be shrinking its massive balance sheet and kindly releasing those bonds into the wild anytime soon.
There are too few Treasury bonds for investors, yet the Fed will continue to hold a big chunk of them.
Obviously, Kocherlakota is making a contrived argument.
Reach for Evidence
Kocherlakota even accidentally admits that QE causes systemic risk:
Without enough Treasury bonds to go around, investors "reach for yield" by buying apparently safe securities from the private sector (remember all those triple-A-rated subprime-mortgage investments of the 2000s?). If such behavior becomes widespread, it can create systemic risks that tip the financial system into crisis."
As we know, QE takes Treasury bonds out of circulation. Therefore, QE leads to a reach for yield, even by Kocherlakota's own admission. The entire quote is accurate, except for the misguided reference to the housing bubble. He's really reaching there.
The apex of the reach for yield phenomenon occurred in 2014 during the Fed's third QE program (QE3). Kocherlakota was a Fed governor at the time. You see, he doesn't want to admit that they caused a reach for yield during his tenure with the Fed, which began in 2009. So, he provides the housing bubble example, which keeps his career out of the picture but simply doesn't make sense in this context.
When the housing bubble peaked in mid-2006, the 10-year U.S. Treasury rate was around 5%. If there weren't enough T-Notes to go around, as he claims, then why was the yield so high?
During QE3, benchmark U.S. high-yield (junk) bond yields hit an astoundingly low 5.2%.
We should be receiving an apology from Fed governors for the capital misallocation that this true reach for yield caused.
Kocherlakota concludes that the government's reticence to issue more debt will sow the seeds of the next financial crisis. This statement is far from altruistic, however, and his entire article promotes a thinly veiled agenda.
The Fed governors - both former and current - are pleading with the government to issue more debt so that the Fed, itself, can buy more Treasuries.
In fact, as I write, the following comment from John Williams, President of the Federal Reserve Bank of San Francisco, is crossing the Bloomberg newswires:
WILLIAMS: FED COULD DO QE4, USE FORWARD GUIDANCE IF NEEDED."
So there you have it - all roads seemingly end with more QE stimulus.
I believe the Fed wants more government debt issuance in order to alleviate concerns about illiquidity in the Treasury market as a result of QE. And they want to conduct more QE in order to boost the stock market, which has struggled to rise without any stimulus.
The S&P 500 Index is hovering around the same level it was at near the end of 2014, right after the Fed stopped QE3. However, the Fed desires higher stock prices in order to produce the "wealth effect."
Clearly, Kocherlakota's article is biased. It really should have been called: "The Fed Wants More U.S. Government Debt to Buy."
Safe (and high-yield) investing...