Corporations preparing for growth in the post Quantitative Easing 2 (QE2) era need seasoned chief financial officers now more than ever.
QE2, which entailed the buying of $600 billion in Treasury securities to finance the Federal budget deficit by expanding the balance sheet of the Federal Reserve, has altered the monetary and fiscal landscapes in ways that only an experienced chief financial officer can navigate.
The balance sheet of the Federal Reserve now has about $3 trillion in assets, much of it being mortgage backed securities from Fannie Mae and Freddie Mac. In 2007, it had about $500 billion in mostly Treasury bonds. How the balance sheet of the Federal Reserve is returned to normalcy will be the defining financial, economic and political event for financial executives in the post QE2 era.
Chief financial officers in preparing their companies for operations should expect the following until 2013:
- Interest rates will remain low.
- Credit will be readily available to borrowers of a high quality.
- The US dollar will remain weak.
- Exporting companies will be at an advantage.
- Imports will be costlier.
Commodity prices will continue to rise.
Disposing of over $2 trillion in assets in the post QE2 era to restore the balance sheet to its traditional size mandates that the Federal Reserve remains committed to a low interest rate environment. Testifying before Congress in April, Federal Reserve Chairman Ben Bernanke stated it. This will require adroit selling of the excess on the Federal Reserve balance sheet as just the need to sell about $2.5 trillion in assets would seem to be enough to send interest rates skyward as massive amounts of liquidity will be drained from the banking system to return the securities back into to the private sector.
The standard used by the Federal Reserve is that buying an extra $200 billion of assets effectuates reducing the funds rate by 25 basis points. With over two trillion more on its balance sheet than in 2007, fund rates are about three points lower due to the expansion of the balance sheet of the Federal Reserve.
According to Russel Napler, a strategist with CLSA Capital, a private equity and money management firm, no fund manager would consider buying US Treasuries for their personal account for less than 7 percent, based on his research. The capital infusion of several trillions of dollars from the Federal Reserve during the economic downturn and the annual operating subsidies valued at hundred of billions of dollars for the financial system through low interest rates is keeping the funds rate and Treasury yields much lower than the market would impose otherwise, penalizing savers but richly rewarding investors. This will continue as the following occurs:
- Low interest rates must be maintained to support the economic recovery, which is still very weak as evinced by recent job hiring data.
- The assets on the Federal Reserve balance were accumulated in support of a low interest policy, which must be continued to keep the prices of these assets high for when they are sold; and
- Higher interest rates will have a tremendous negative impact on political incumbents in the November 2012 presidential elections.
Obviously, having to dispose of these assets ensures that interest rates will have to be kept low by the Federal Reserve as it is now in the position of and on the side of the investor class. As any chief executive officer or chief financial offer well knows, any asset can quickly become a liability when the market turns against it. This phenomenon devastated Wall Street with Level III assets plunging in value during the 2008 meltdown (many of which ended up on the Fed balance sheet).
At present, the market for credit instruments has improved significantly as a result of the low interest rates being offered by investment grade vehicles. In a recent transaction, Citigroup was able to sell $12.7 billion in non-investment grade assets at prices higher than those being carried on its books. In a yield hungry world engendered by the Federal Reserve’s low interest rate policy, instruments previously shunned such as mortgage backed securities and “junk” corporate bonds are now going at a premium.
A recent article in the Financial Times, "Will QE Make Money," detailed how the Bank of England has booked a profit from its purchase of toxic assets. The low interest policy of the Federal Reserve is allowing it to operate as the most imposing market maker in history for the unloading of the assets on its balance sheet.
Should the Federal Reserve allow for interest rates to rise after QE2, however, it would be destroying the value of it’s almost $3 trillion balance sheet. Not only would the prices be devastated, the market for the assets from the balance sheet of the Federal Reserve would deteriorate immediately. The Federal Reserve would find itself in the position that any number of financial houses found themselves in during 2008: unable to move product that was carried on the books and provided much of the net worth of the institution.
With the collapse of the value of the Federal Reserve’s balance sheet would also be the collapse of the financial markets, the collapse of the housing market, and the collapse of the job market in the U.S. Office holders up for reelection in November 2012, from The White House to both Houses of Congress to state houses across the country, would be defeated.
The legacy of Chairman Ben Bernanke and the efforts and expenses (trillions and trillions of dollars) of all Federal Reserve programs to resuscitate the financial sector since 2007 would be tattered and destroyed. In the post QE2 period, low interest rates will last until 2013 as the Federal Reserve must protect the value of trillions in assets on its balance sheet as it seeks to return to a state of normalcy, along with the rest of the economy in the United States. Chief executive and chief financial officers should adopt the following stances:
- Assume low yields for any corporate treasury operations, which will favor investing over saving. Bill Gross, Founder of PIMCO, expects this cycle to continue for the next 15 years.
- If there is a need for borrowing, the time is now. The Federal Reserve is a political animal. QE2 did not go into effect until after the November 2010 elections. Rates will stay low until after the November 2012 election.
- Expect economic conditions to remain weak. The Federal Reserve obviously does, or interest rates would be rising to control inflation.
Companies must prepare for these challenges with capable chief financial officers who have worked under these conditions before. An outsourced CFO firm can provide those with the most fitting experience for these demands.