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The Fed’s Plan to Crash Your Portfolio

The Fed matches expectations … why the Fed might actually want to crash the economy … it’s about to incur historical losses … a “win” for the Fed is a “loss” for you

Today, in a widely-expected move, the Fed raised rates by 75 basis-points to a target range of 3% to 3.25%.This is the highest that rates have been since early 2008. And they’re headed higher…The Fed’s “dot plot” shows that members expect to raise rates by at least another 1.25% percentage points in the final two meetings of 2022.In his press conference, Federal Reserve Chairman Jerome Powell continued his recent commitment to ending inflation, saying “we will keep at it until the job is done.”He went on to say that there will be no interest rate cuts until members are “very confident” that inflation is coming back down to 2%.He also said that no one knows if the fight against inflation will result in a recession.On the dovish side, stocks rallied when Powell said, “at some point, as the stance of policy tightens further, it will become appropriate to slow the pace of rate hikes while we assess how our cumulative policy decisions are affecting the economy and inflation.”As I write shortly before 3:30 PM ET, the market has been oscillating between “hope” and “fear” as it has digested the policy statement and Powell’s comments. It’s been a rollercoaster, but “fear” appears to be in the lead.Below is a one-minute chart of the S&P 500 on the day, as of the time of this writing.

A chart showing the S&P per minute the day of the Sept Fed announcement. It's a rollercoaster
Source: StockCharts.com

Where the market will close the day is anyone’s guess.

As we stand now, Wall Street is wrestling with a host of questions as it tries to guess what the Fed does next

At what level will the Fed stop hiking rates? … When we get to that level, how long will the Fed pause before actually lowering rates? … What is enough “proof” to the Fed that inflation is definitely on its way back to 2%? … Is there an economic pain-point at which the Fed cries “uncle” and turns dovish, even if that wasn’t the original plan?These are reasonable questions, but they’re the wrong questions.If we want to know what the Fed is going to do, we have to diagnose the source of the pressure it feels, then put ourselves in its shoes to determine the fastest way to relieve that pressure.When we do this, it points us toward an uncomfortable answer…What if, while the Fed is telling us that it’s trying to thread the needle to achieve an economic soft landing, it actually wants an economic and market crash?But why in the world would that be the case?Ego, extreme embarrassment, and policy conflicts-of-interest.Let’s fill in some details.

The Fed’s wonderfully-profitable run is up

To start, think of the Fed as just an ordinary bank.And how do banks make money?Well, they pay interest to you on your deposits. Meanwhile, they earn interest from money they loan out to individuals and businesses. The interest rate they pay is smaller than the interest rate they earn. This spread is their profit.Though the Fed isn’t a “for profit” institution, it operates in a roughly similar way, with a twist.Its “money in” comes from income spun off by the assets on its balance sheet. Think U.S. Treasuries and mortgage-backed securities.Its “money out” goes to the interest it pays on bank reserves.Simplistically, the difference between the Fed’s “money in” and “money out” shows up as either a profit or a loss. Any profit goes to the U.S. Treasury. We’ll come back to losses.Now, since 2008, business for the Fed has been very, very good.Why 2008?Well, that’s when the Fed started quantitative easing (QE). And with QE, the Fed took short-term rates to zero. So, it basically had to “pay out” nothing.Meanwhile, it was still earning interest income from the assets on its balance sheet.Here’s the Fed from back in January, announcing the enormously profitable results of its recent operations:

The Federal Reserve Board on Friday announced preliminary financial information indicating that the Reserve Banks had estimated net income of $107.8 billion during 2021, of which $107.4 billion was remitted to the U.S. Treasury as required under the Federal Reserve Act…The Federal Reserve Banks’ 2021 estimated net income of $107.8 billion is an increase of $19.3 billion from 2020.

It turns out, the Fed has averaged a “profit” of $72 billion per year since QE began in late 2008. For context, this is nearly three times the $26 billion per year that the Fed averaged over the previous decade. That’s a cumulative gain of more than $1 trillion.Thanks, QE!But as you know, QE is over. Actually, it’s not just “over” – the Fed is now reversing QE with a policy known as quantitative tightening (QT).Cue the ominous thunder clap off in the distance…Now, if the Fed makes loads of profits with QE, might they be looking down the barrel of massive losses with QT?

The Fed is on the precipice of historic losses

For a decade or so, the Fed has been paying out very little because short-term rates have been effectively zero. This means that nearly all the income it received from its balance sheet holdings was just gravy.This dynamic is now being thrown out of kilter as short-term rates explode higher. The Fed is going to have to pay out hundreds of billions of dollars.Meanwhile, many of the Fed’s treasury purchases in recent years came at much higher prices than today, which means much lower yields. So, those lower yields may not be doing a fantastic job of offsetting its new out-going cash flows.Plus, higher treasury prices from past purchases mean that if the Fed tried to sell any of these assets (rather than let them simply roll off the balance sheet), they’d likely incur capital losses. More pain.Let’s jump to the American Enterprise Institute (AEI), for the net-net:

We estimate that at the end of May 2022, the Federal Reserve had an unrecognized loss of about $540 billion on the market value of its $8.8 trillion System Open Market Account (SOMA) portfolio of Treasury bonds and mortgage securities.This loss, which will only get larger as interest rates increase, is equivalent to 60 percent of the Fed’s total assets in early September 2008, and more than 13 times the Federal Reserve System’s current reported consolidated capital of $41 billion.The Fed’s liabilities—primarily Federal Reserve notes and member bank reserve balances—are half a trillion dollars larger than the market value of the assets the Fed owns.Any other financial institution this economically insolvent would be closed…

The AEI then walks through a potential hypothetical with the following takeaway:

…We project that the Fed would post an annualized operating loss of $62 billion should short-term rates rise to 4 percent.Such a loss is equivalent to 150 percent of the Federal Reserve system’s total capital. 

With that context, earlier today, Fed officials signaled their intention to push rates not just to 4%, but to 4.6% in 2023. Meanwhile, the Fed’s “dot plot” showed Fed members don’t expect a rate-cut until 2024.Cue the second, much closer rumble of thunder…Now, this prompts an immediate question: Could the Fed go bankrupt?Fortunately, no.No matter how big the Fed’s losses grow, it can’t “fail.” It will continue to print money.

But that doesn’t mean this isn’t a nightmare situation for Powell & Co.

One, this is an optics disaster – especially coming off the whole “transitory inflation” debacle.Until now, the Federal Reserve System has only had one year in which it posted an operating loss. That was 1915.So, this isn’t just “egg on the face,” this is the Fed crashing face-first into an all-you-can-eat omelet buffet.Two, if the Fed’s losses get out of control, it could, in fact, impact policy, which takes us right back to point one – massive embarrassment, since impacted policy could reveal a conflict of interest for the Powell and the Fed members.To better understand these two points, let’s circle back to what the Fed does when it incurs a loss.The Federal Reserve Board’s official position on losses is it would just create the money needed to meet operating expenses. Meanwhile, it would offset the newly printed money by creating an imaginary “deferred asset” on its balance sheet.In the future, when the Fed was profitable again, it would reduce the deferred asset balance to zero before resuming remittance payments to the U.S. Treasury.As to this being embarrassing, here’s the AEI:

The original authors of the Federal Reserve Act would never have approved of allowing the Fed to create an imaginary “deferred asset” as a mechanism to hide the fact that the Fed is depleting its cushion of loss-absorbing assets while paying banks interest on their reserve balances, since the Act itself requires member banks as stockholders to be liable for Federal Reserve district bank operating losses. 

You can be certain that axe-grinding politicians will jump on Powell & Co. as this situation deteriorates.And what about the potential for massive losses to impact Fed policy decisions?Back to AEI:

Should this occur, it would directly impact the FOMC’s primary monetary policy tool for constraining inflation.Moreover, some member banks’ capital positions could become tenuous should the Federal Reserve Board require district reserve banks to pass large operating losses on to their shareholders. 

I know all of this is a bit confusing, and we don’t have the space to dig into additional details, so here’s the bottom-line takeaway:Huge operating losses for the Fed would be a public image nightmare. And if the losses grew large enough, it could create a conflict of interest for the Fed’s policy decisions going forward, which would only intensify the public embarrassment.For these reasons, the Fed is desperate for a way to return to a low-interest-rate environment. The problem is that it’s hamstrung. If it turns dovish prematurely, then inflation burns up the economy.So, is there some miracle solution that simultaneously kills inflation while also returning the world to a low-interest-rate environment?Yes, there are two such miracles.One, inflation naturally goes away on its own very fast (highly unlikely as core inflation is still on the rise).Two, the Fed “accidentally” crashes the stock market, housing market, and the economy.

The best option for the Fed is the worst option for you

Why is a crash a win/win for the Fed?Because an “everything crashes” situation kills inflation by choking out consumer demand everywhere – for houses, for consumer goods, for risky investment speculation…Meanwhile, a crashed economy provides the backdrop for the Fed to “save the day” by showing up as the white knight who has come to slash interest rates.The Fed wins – inflation disappears and interest rates retreat to 0.5%.Meanwhile, all it costs is your portfolio value, home equity, and possibly your job.If this sounds a bit “conspiracy theory,” I get it. But think through the Fed’s Catch-22…Consider the pressures it’s under… the historical significance of the losses it’s about to incur… consider the embarrassment it suffered due to “transitory inflation” … factor in the pressures of politics and spin… and be realistic about where you and I rank on the Fed’s priority list compared to everything else.In light of all of this, what is the simplest, most effective solution from the Fed’s perspective?If you ask me, investors expecting a dovish pivot from the Fed might be overlooking the far-more-complex issues that are driving Fed decisions today.Have a good evening,

Jeff Remsburg


Article printed from InvestorPlace Media, https://investorplace.com/2022/09/the-feds-plan-to-crash-your-portfolio/.

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