Stage 10 – Reductions in the Fed Balance Sheet Spikes Yields

Stage 10The tenth stage of America’s Financial Endgame™ will occur when actions taken by the Federal Reserve to stabilize prices ripple through the financial markets and economy.  The likely action that will be taken by the Federal Reserve is a reduction in their balance sheet through Open Market Operations.  What this ultimately means is that the past decision to purchase large amounts of treasuries will be reversed and the treasuries currently held on the Federal Reserve balance sheet will be sold.

The effect that this will have on the economy is the exact opposite of what happened when the cycle of quantitative easing was initiated.  The sale of treasuries into the open market will place downward pressure on prices.  As the price of treasuries decline, it will increase the effective yield on treasury notes already in force. Since it is unlikely that the Fed will be willing to take action to reduce the aggregate money supply until inflation is already running high, there will be many follow-on effects that ultimately ripple through the economy.

The first effect is that the cost of borrowing for the government, for businesses, and for people seeking to gain a mortgage loan will increase.  This will generate the net effect of increasing the amount of resources the government must dedicate to debt repayment, increasing the effective cost of debt capital for businesses, and increasing the effective cost of purchasing a home since the higher interest rates will reduce the net purchasing power of prospective homeowners.

Stage 10aAs the cost of borrowing increases, it will place downward pressure on the price of all the things that are purchased with borrowed capital.  The most impactful effect will be on the price of housing.  Without historically low interest rates to increase the purchasing power of homeowners, there will inevitably be a contraction in the rate of home building, buying, and selling.

A corollary to this is the opportunity that is implicit in the current interest rates for investors.  The looming increase in the effective cost of purchasing a home will inevitably result in an increased number of people who rent vs. own their primary residence.  This creates a unique two-stage window of opportunity for investors:

  1. Purchasing income property at the current historically low interest rates allows you to lock-in the current rates for up to three decades.  This is very significant since the current cost of debt for mortgages is very near the effective rate of inflation, and is likely to be lower than the future effective rate of inflation.
  2. The anticipated increase in the number of people who rent will place upward pressure on rental rates.  This will create an especially profitable situation for people who purchased cash generating properties at low interest rates since the rental rate will be increasing while the mortgage payment stays flat.

However, there are second-order effects that need to be considered as well.  The first of these is the impact on the stock market.  In a near-zero interest rate environment, the stock market becomes a magnet for investment capital since the competitive yields from bonds are extremely low.  This has the net effect of creating a price bubble in the stock market as more capital flows in, due to the desire for yields.  As the yields offered from bonds rises, the relative attractiveness of bonds to investors will increase.  This is all but certain to divert investment capital away from the stock market, and is likely to create a very significant downward movement in stock prices.

This will create a situation that is devastating for many traditional investors, and that is exceptionally lucrative for “smart money” investors.

  • The downward movement in equity prices from capital leaving the stock market will inflict significant losses on many people and pension funds who are invested in the stock market.
  • The increase in bond yields that results from the Federal Reserve reducing the size of their balance sheet will place downward pressure on prices for bonds currently outstanding.  This will inflict significant losses on many people and pension funds who are invested in the bond market.
  • The net effect of all this will be a buying opportunity for investors who have avoided the temptation to chase popular sentiment and buy into an over-valued market.

As we can see, the effects that will ripple through the financial markets and broader economy are very significant.  The financial future of an entire generation will be predicated on how they are financially positioned in advance of these events, and the financial decisions that are made in response to them.

In the next stage of America’s Financial Endgame™ we will examine the effect that higher bond yields will have on the US government’s debt and deficit.

Leave A Response