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Bond Yields to Soar When Federal Reserve Starts Selling Assets
 

Bond Yields to Soar When Federal Reserve Starts Selling Assets

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Since the financial crisis and "Great Recession," the Federal Reserve has done an unprecedented amount of easing to stimulate the economy and lower the unemployment rate. The Federal Reserve has done an excellent job of helping the economy recover from the greatest calamity since the Great Depression with no help from the politicians in Washington.

Bond Yields to Soar When Federal Reserve Starts Selling AssetsThe Federal Reserve the central banking system of the United States and was created in 1913, after several financial panics in the prior years. The Federal Reserve has a mandate of maximum employment and stable prices with a low rate of inflation.

To help the economy along, the Federal Reserve has been buying long term bonds and mortgage-backed securities (MBS) to the tune of $85 billion a month. These actions are designed to drive long term bond yields lower and to lower mortgage rates to help the housing market. The Federal Reserve has been buying these securities for a while now.

The Federal Reserve has accumulated a balance sheet of these assets and the balance sheet currently stands at a record $3 trillion. When the Fed starts unwinding the $3 trillion in assets, bond yields, CD rates, and mortgage rates will move higher. At least that is what many investors and economists believe will happen.

The Fed selling their holdings won't directly drive rates and yields higher because they plan to sell their holdings in an orderly fashion. What has everyone worried (including the legendary investor Warren Buffett) is that markets will be spooked once the Fed stops buying and starts selling assets.

The Fed's selling long term bonds and mortgage-backed securities combined with investors selling those assets will send rates higher. Bond yields move in the opposite direction of bond prices; when bond prices move lower, bond yields will move higher. Investors have already started sending long term bond yields higher.

Back in July of 2012, 10 year bond yields hit a low of 1.40 percent. Two weeks ago, yields were just above 2.00 percent. This is more than a 40 percent increase in yields in less than a year. Current 10 year bond yields are back below 2.00 percent at 1.89 percent. No one knows exactly when the Fed will stop buying long term bonds and MBS but the Fed has signaled they plan to keep their "aggressive" policy stance until the unemployment rate falls below 6.5 percent.

I believe once the unemployment rate starts falling from the current rate of 7.9 percent, the Fed will slow their purchases of bonds and MBS. Once the unemployment rate falls below 7.00 percent, the Fed will stop buying assets and start slowly selling assets to unwind their balance sheet.

Over the past several years, the Fed's policies have made a lot of money for the Federal government. Last year alone, the Fed's profit was $91 billion. Unfortunately, the Fed will start losing money when they start selling bonds since they paid higher prices for these bonds than they will be selling them for in the future.
Author: James Martin
March 6th, 2013