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Quantitatively at ease?

|Includes: ProShares UltraShort 20+ Year Treasury ETF (TBT), TLT

There has been a lot of debate, nay, outrage, about the Fed's balance sheet.  Fear and loathing is particularly reserved for quantitative easing, the dreaded "printing presses" which daily imperil our liberty and our very dignity.  The flag and pitchfork-toting know-it-alls who so vilify the evil Bernanke would have us return to the halcyon days when everyone took care of his own business, with the exception of the externalities associated with SUV-, coal, beef- and McMansion-related emissions, as well as the obesity epidemic.  But I digress.

Lets have a few common sense reflections on the realities of the Fed's balance sheet, and particularly the offending $1.25 trillion in newly minted mortgages. First off, lets look at these positions from the point of view of credit risk.  Anecdotally, we have all heard about how tight lenders' underwriting standards have been since all hell broke loose. Sure, rates have been low, but it's been difficult to get a loan because banks have insisted on things like down payments and that borrowers have jobs.  So it's generally safe to assume that the borrowers on these mortgages belong to the 90.3% of the population that remains employed, and perhaps even the 83.1% of the population that has a full time job.  So the cashflows off of these mortgages should be pretty solid.  Roughly $60 billion a year right there. Shoot, I'd take it.  And the Fed can either hold that as cash or, if the mood strikes it, just hit the delete button. And there's $60 billion leaving the money supply.

The Wall Street Journal a day or two ago noted that, according to the New York Fed's calculations, the Fed could shrink its balance sheet by $140 billion just by letting Treasuries expire and not buying new ones.

And then there's the idea of selling some of the Fed's MBS back into the market. It will have to happen sometime. The same article in the Journal quoted the president of the Minneapolis Fed calling for sales of $15 to $25 billion a year to shrink the MBS position to nothing in 5 years.  It does indeed sound like a lot, and would likely drive interest rates up.  But, as we've noted, if we're effectively taking $5 billion a month in cash out of circulation just by receiving the coupon payments on that debt, that starts to offset some of that.

Then there's the question of the retail American investor's newfound love affair with bonds, which we've somehow taken a shine to even though we see that we're staring down the barrel of a rising interest rate environment. There have been net monthly inflows into bond mutual funds for nine months or so (more retail than institutional money), and the mutual fund trade association the Investment Company Institute shows year to date to February inflows into taxable bond funds of $44 billion, another $6 billion or so into hybrid funds, and another $9 billion or so into munis. And, yes, a lot of this is going into corporates, and some of it is going abroad. But we can bet that the goings on in Greece, Portugal and Spain will incite new risk aversion and flight to quality. I'm certainly not qualified to forecast interest rates, but my guess is that as interest rates rise here, domestic investors will be even more interested in Treasury and agency MBS issuance -- so long as mortgage underwriting standards remain pretty disciplined.  I think there are a lot of 401ks that are dollar-cost averaging into bond mutual funds, and that they'll keep doing it because people have learned about overallocating to equities.

My point is, we should breathe and relax a bit. Yes we are issuing a lot of debt. Yes prudence and sobriety in fiscal policy are warranted. But neither Bernanke, nor Geithner, nor Obama are out to bankrupt America, nor are they about to.


Disclosure: FGMNX, VFICX

Disclosure: TIPS