Risks of Monetizing U.S. Government Debt

The Federal Reserve has been using some unusual tactics to offset the effects of the credit crisis of 2007-2009. Individual investors should have a basic understanding of what these Fed activities are and what kinds of risks they present to their portfolios.

Video Analysis: Monetizing Debt – Part 1

This article series will specifically address the concept of “debt monetization”, which has become a very popular set of terms to use within the financial news media to describe the partnership between a government deficit spending plan and the Fed’s open market activities..

Debt monetization is not the same thing as “printing money” but it has many of the same effects.

Debt monetization describes the process of turning U.S. Treasury debt and private corporate debt into money. Simply stated, this happens when the Fed buys Treasury and corporate debt on the open market.

When the Fed buys debt in the market its purchase increases the money supply.

During normal economic conditions the Fed will buy and sell debt to manage interest rates. When they buy debt and increase the money supply, interest rates should fall. Conversely, if the Fed sells debt, interest rates will rise.

The Fed may want to raise interest rates to keep the economy from overheating and it may want to lower rates to stimulate a sluggish economy.

During the credit crisis the Fed had had to buy an unprecedented amount of public and private debt to keep rates low. This process is sometimes referred to as quantitative easing and is ostensibly a temporary strategy that will be rolled back when the crisis eases. Eventually, the Fed would like to get the debt they hold back into the market, which theoretically would reduce the money supply by demonetizing the debt.

The Fed needs to buy this debt because the private money markets are unwilling or unable to do so in the quantities necessary at desired yield levels. Private companies have low value debt they need to get off their balance sheets and the U.S. government needs to have money to fund a budget that is in deficit. If the Fed did not buy the debt, yields would rise and it could significantly postpone economic recovery.

This presents a series of very unusual questions for investors. The Fed is essentially the largest market participant and they have clear stated objectives about where they want prices and yields to go. Should individual investors bet against the Fed? Is the Fed taking on too much risk? How do individual investors hedge this risk or take advantage of another potential bubble?

In the next article in this series I will discuss what the known risks of the Fed’s strategy are and some ideas individual investors can use if things don’t work out as planned. Ultimately, individual investors need to be flexible, educated and aware of what is going on around them. We can’t forecast the future but we can prepare to take advantage of market changes when they do happen.

In order to fully understand why debt monetization in its present scale is risky I think it is important to consider some of the specific strategies being used by the Fed. The similarities between those activities and some of the causes of the last asset bubble are interesting. To see part one of this series, click here.

Video Analysis: Monetizing Debt – Part 2

I would suggest that the Fed has essentially done three things through a variety of new and expanded programs.

1. Through the Primary Dealer Credit Facility (PDCF) and other measures the Fed is now able to loan directly to a larger pool of borrowers.

2. Through the Term Asset-Backed Securities Loan Facility (TALF) and other measures the Fed can accept new forms of collateral (like mortgage backed securities).

3. Through a number of other changes the Fed has extended the time frame on lending facilities. Some of these time-frames have been shortened but not all.

These extraordinary measures are similar to the kinds of things happening during the housing bubble. Borrowers had to provide fewer and more flexible assets for collateral, terms were extended and requirements for eligible borrowers were relaxed.

These measures were all taken by the Fed to help ease the blocked credit markets. Theoretically they can be reversed (to a certain extent) once the credit markets start operating more “normally,” however, things may not go as hoped. Through these measures and the Fed’s large Treasuries purchases a debt bubble has been created.

In the case of the housing and mortgage market, these same strategies led to a bubble that popped and resulted in significant asset deflation. In this case, if the current Treasury debt bubble bursts, yields could rise dramatically because Treasury debt prices would fall.

Rising yields and accelerating inflation can be good for commodity investors but it is tough on a variety of other assets like stocks and bonds. Prudent investors should be diversified and thinking about the effect of these risks, should they materialize, on their portfolio.

It is important to understand that no one can tell the future. The Fed’s plans may turn out great. No one knows yet what will happen for sure. There is clearly an erosion of confidence in the Fed happening but that alone doesn’t guarantee a crash. The key is being prepared for either eventuality.

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