Aug 03, 2013

Fox Business News has an article showing the effect of the recent rise in interest rates. Recall that interest rates have risen by 1% in the past two months. That does not sound like much, but it has caused new bond yields to rise over 66%. The previously issued low-interest bonds thus drop in value by 66%.

Because China and other nations are no longer purchasing Treasury bonds at previous rates, the Fed has stepped in, purchasing them at near-zero interest rates. Bond values are determined by their yield on interest. But when interest rates rise, the value of the previous low-interest bonds plunges. The Fed has had little choice but to purchase the Treasury bonds to keep the Federal Government solvent through the creation of new money, but there are financial consequences that they may not be able to avoid. First, debasing the currency requires a great deal of manipulation to keep inflation under control. Secondly, a rise of just one more percent in interest rates could make the Fed itself insolvent.

Here is an article that estimates the losses at the Fed.

http://m.foxbusiness.com/quickPage.html?page=32811&content=95630138&pageNum=-1

Bond Losses at Federal Reserve Top $192 Billion

The yield on 10-year U.S. Treasuries (^TNX) has surged 66% over the past three months. And bond investors, especially those with jumbo-sized positions, are getting hammered. How much money has the Federal Reserve lost?

At the end of July, the Federal Reserve held $1.98 trillion in U.S. Treasuries. (See chart below) That figure represents just over half of the Fed's $3.6 trillion balance sheet.

Scott Minerd, the Global Chief Investment Officer at Guggenheim Partners notes: 

"Our estimate shows that the spike in bond yields since the first quarter of this year has caused a mark-to-market loss of $192 billion on the Fed's holding assets, equivalent to approximately all of the unrealized gains that the Fed had accumulated since it began to implement quantitative easing in late 2008. Although in keeping with their own accounting principles the Fed does not record mark-to-market losses, a continued increase in bond yields would incur actual losses should the central bank decide to sell assets."...

But that's not all.

If interest rates continue to head higher, the value of the Fed's liquid assets that it could sell would decline and further undermine its capital cushion. And if the velocity of rate increases intensifies, the Fed, with only $62 billion in capital, could see its entire capital base completely wiped out.