Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

How Central Bankers Manage a Balance Sheet

By

Despite the latest word from the Fed, the risk remains that Treasury owners will see a decline in the value of their securities through higher interest rates.

PrintPRINT
One of the things that many folks have discussed ever since the collapse of Lehman Brothers in the fall of '08 has been the Federal Reserve's actions to prevent the liquidity crisis from turning into a solvency crisis.

Terms like "zero bound," "unconventional measures," "quantitative easing (QE)," and the derivatives of QE (QE2, QE3, etc.) have been used repeatedly.

You know we're in a different world now because in talking about monetary policy, the lines have blurred between using terms related to economics, the building of cruise ships, and the zombie apocalypse.

But truth be told, things actually are different now, and the usual levers a central bank would use to adjust monetary policy (i.e., adjusting interest rates), don't work as rates approach zero. And it's going to be a while before those levers are used again. From the Fed's latest statement (emphasis, mine):

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions -- including low rates of resource utilization and a subdued outlook for inflation over the medium run – are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.

Exceptionally low rates "at least through late 2014" and extending the average maturity of their securities holdings. To get a sense of how big the Fed's holdings of securities have gotten, I took a screen shot from the Fed's website that shows how big the Fed's balance sheet is these days:


Click to enlarge

Clearly over the last three years, the Fed's securities purchases (Treasuries, mortgage-backed securities, and Federal Agency debt) has been the driver of the growth in the Fed's balance sheet. And that growth has taken the Fed's balance sheet to sizes we have never seen before, which has the potential to introduce risks the Fed has never had to deal with directly. I'll get to that a little bit later.

But the Fed hasn't been the only one buying Treasuries. Take a look at this table from the recent paper published by the CME Group, "Risk Management for Central Bankers." As the table shows, Treasuries have been quite popular with foreign investors as well:


Nevertheless, the risk remains that Treasury owners will see a decline in the value of their securities through higher interest rates. To see this illustrated, we can use two measures of interest rate sensitivity: duration and the dollar value of a basis point (or DV01).

Duration is measured in years. The theory is that the longer the duration of a security, the more sensitivity that security exhibits to changes in interest rates. It makes sense because over short time periods, you shouldn't see big changes in interest rates, if at all. Over longer periods, you're bound to see some change in rates. As for DV01, that just measures a change in a security's value given a one basis point change in rates.

First, let's look at duration. Suppose I have two 10-year bonds, one with a 6% coupon and another with a 7% coupon. Initially, both are priced at par, meaning 10-year yields are 6 and 7 percent for each bond. A 6% 10-year bond has a duration of 7.80 years, while a 7% 10-year bond has a duration of 7.51 years. So higher coupons and higher rates have relatively lower durations.

The DV01 on a 6% 10-year bond is higher than a 7% bond as well, since the 6% bond's DV01 is $0.74 on a $1,000 note, while a 7% bond's DV01 is $0.70 on the same $1,000 note. Multiply this thousands of time over, and you can see when bonds and their associated swaps and derivatives contracts are traded, these measures matter. A lot. And as the Fed has been buying massive amounts of Treasuries, these measures are going to start mattering a lot more to the Fed as well.

So what should be done to hedge against these rate movements? Well, there are several instruments you can use and a variety of strategies to employ. Since rates really can't go any lower, the scenarios to hedge against are rising rate scenarios.

Be they bear steepeners (where the long end of the yield curve rises faster than the short end) or bear flatteners (where the short end rises faster than the long end), the portfolio needs to be protected. If you're using futures, selling Treasury futures will shorten your duration and make your portfolio less rate-sensitive.

You can also use options on Treasury futures to give you greater flexibility in managing your portfolio's duration and yield curve exposure. The CME Group paper does a nice job in walking through some examples of how to use Treasury futures and options to manage interest rate risk.

But the question is, when should you deploy such a strategy? One of the most basic rules of hedging is "hedge when you can, not when you have to." Because if you wait until it's needed, you may not be able to buy the hedge you want, or if you can, you will pay an exorbitant amount for it.

But in the meantime, I think we're all just sitting around waiting for the economy to get off the mat.

Twitter: @japhychron
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE