Caitlin Long, head of Corporate Strategies at Morgan Stanley, shared a report they have distributed to their clients. (She gave permission for me to quote from it.) Caitlin is a former student from my Mises Academy classes, and was one of the first people Carlos and I interviewed in our Lara-Murphy Report. Here’s Caitlin:
* Several companies have recently asked us for an analysis of the Federal Reserve tapering its quantitative easing programs.
* One factor that is not widely analyzed is the Fed’s own balance sheet, which could be a constraint on how far and how fast the Fed permits interest rates to rise in the US
* We calculate that a 143bp parallel rise in the yield curve would cause a drop in the market value of the Fed’s assets that exceeds the Fed’s own equity capital (as of May 15).
— economically, the Fed’s balance sheet is a leveraged portfolio of bonds whose value climbs when interest rates drop (and vice versa) — see chart below
— key facts (as of May 15):
* leverage: the Fed’s $55.2 billion of equity capital supports $3.4 trillion of assets, for a leverage ratio of 61:1
— adjusting for the Fed’s $214.5 billion of unrealized capital gains (as of 12/31/12), its market-value adjusted leverage ratio is 13:1
* duration mismatch: the Fed’s maturity extension programs have caused its asset duration to reach 5.91 years, compared to its liability duration that is mostly “on demand” (i.e., zero), for a duration mismatch >5 years
— our calculation used the market value of each bond in the Fed’s portfolio as of May 15, 2013 (sources: http://www.newyorkfed.org/markets/sysopen_accholdings.html, CapIQ)
— the Fed balance sheet’s capacity to absorb higher interest rates has deterioriated quickly, as the 143bp capacity is down from 185bp as of last October (owing to higher leverage and reduced unrealized gains since then)