The Fed's Prisoner Dilemma: Interest Rates Too Low for Too Long

The Prisoner Dilemma is based on the example of two prisoners who are told that if one testifies against the other, the one who testified will go free, but if both testify against the other, both will be jailed – a conundrum about courses of action that don’t result in the ideal outcome. We believe the Federal Reserve (Fed) will try to manage expectations so that the Treasury yield curve does not adjust too violently. They may point to large underemployment, which could still look ugly for a while, to justify holding rates down. Maintaining zero for as long as possible reduces the probability of exploding debt service costs, but the math is grim.

With nearly $17 trillion of debt, a 100 basis point increase in rates would raise the interest burden on the Federal government by $170 billion a year. This would wipe out the recent budgetary efforts to reduce the deficit.

Questions about the Fed’s Exit Strategy

In a normal credit cycle, the first stage of interest rate normalization would be followed quite rapidly by the next stage: rising rates. On average, over the last 40 years, the time frame between the low point in the yield curve and the first rate rise is about 14 months. But the current cycle is clearly different. Quantitative Easing (QE) – the Fed’s bond buying program – has introduced a wrinkle. The balance sheet, at $3.47 trillion as of 6/19/2013, will likely hit $4 trillion by the end of this year. Markets are now grappling with the Fed’s exit strategy from QE. The question is whether the “unwind” of the balance sheet would materially alter the Fed’s timing and any misstep affect the U.S.’s economic trajectory.

About that Balance Sheet, Mr. Bernanke – A Review of the Fed’s Assets

As of June 19, 2013, The Fed’s balance sheet held approximately $3.5 trillion in securities. This had not moved materially since June of 2011 when the Fed stopped expanding its purchases and engaged in reshaping “Operation Twist.”

Danger Duration 2 a

However, beginning in January 2013, the Fed began buying $85 billion a month in additional Treasuries and MBS*. Projecting out through the end of the year, this will leave their balance sheet at close to $4 trillion. At this point, given the likelihood of accelerating economic activity, we believe the Fed will begin tapering their purchases. Below is our expectation of what the Fed’s balance could look like once it stops purchasing securities and allows the portfolio to naturally amortize.

Danger Duration 2 b

Shorter-dated treasuries and the average life of the MBS pools should allow the balance sheet to drop by half between 2014 and 2020 without having to resort to outright sales of any security. Therefore, it is reasonable to assume that the sequencing of the Fed’s withdrawal of accommodation will go something like this:

  1. As economic milestones draw near, QE can be reduced to match amortizations, neutralizing its effect on the financial markets.
  2. Once milestones have been achieved, QE can dwindle to zero and the natural path of amortization will draw down the Fed’s balance sheet by $300-400 billion a year.

Looking forward, there are a number of elements that we think will fuel the strengthening economic trajectory. In a Pioneer Blue Paper, The U.S. Dollar, Awaiting the Upcoming Bull Market, we highlighted how investments in energy and manufacturing will help provide strong tailwinds for the dollar over the next several years. This, combined with massive monetary accommodation in much of the developed world could propel U.S. economic activity and employment skyward beyond the drag of tax hikes and sequestration. As such, we think investors are being lulled into a false sense of security that rising rates are a long, long way off in the future.

To read more about the impact of rising rates on bonds, click on Life Inside an Interest Rate “Black Hole”, the first in a series of three papers titled The Danger of Duration in Investor Portfolios.

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