Does the Federal Reserve Need ROI?

In the broad financial world, 10-year Treasury rate is often denoted as “risk-free” rate. The strength of the dollar and rate is highly dependent on “good faith”/credibility. Technically-speaking, central government like the Fed can still function on a loss. The recent Swiss National Bank situation well supported this fact. On January 15 of this year, when the SNB abandoned its three-year effort to cap the currency and let the franc soar, everyone knew the central bank faced a massive foreign exchange loss. The first-quarter impact is now documented. According to the SNB, its foreign exchange investments lost CHF41 billion, or about 6½% of Swiss GDP, in that three-month period. I remembered seeing everyone panicking about the sudden drop in CHF value in the morning of the announcement and numerous small and medium-sized FOREX trading firms experienced a 40-50%+ decline in stock value. However, in the following weeks after the event, the exchange rate seems to find a more balanced equilibrium.

At the end of the Great Recession a few years ago, numerous central banks have embarked on a quantitative easing (QE) journey . the first central bank to undertake quantitative easing – already in the late 1990s – the Bank of Japan (BoJ) was the first major central bank to perceive a significant risk to its capital; its worries about the potential need for recapitalization may have made it less forceful than economic fundamentals warranted. Not anymore. Today, the BoJ is in the midst of what is arguably the most aggressive monetary expansion of any major central bank, making it vulnerable to a range of portfolio risks: in addition to its massive holdings of government bonds, the BoJ’s assets include corporate equities and real estate investment trusts. However, due to BoJ’s aggressive QE strategy, not only has the Japanese Yen experienced an appreciation of 30%+ in just the past few years, Japanese citizen’s spending and purchasing power has been suppressed (both from the currency fluctuation and Prime Minster Abe raising sales tax incrementally for the next few years).

The Fed primarily faces interest rate risk – on both sides of its balance sheet. On the asset side, rising bond yields would lower the value of its long-term securities, which consist of Treasuries and federally-backed mortgage securities. Witha one-percentage-point rise in market yield lowers the value of the bond portfolio by roughly 7%. Given that the bond portfolio is currently worth $4.2 trillion, this implies a loss of nearly $300 billion per percentage point of upward shift in the yield curve. This hypothetical loss exceeds the sum of capital ($58 billion) plus unrealized capital gains ($183 billion) currently on the balance sheet. On the liability side, the Fed plans to tighten monetary policy by raising the interest rate that it pays on excess reserves and on reverse repo agreements. In theory, the rising cost of carry of its large portfolio could eliminate the Fed’s profits and its ability to pay remittances to the Treasury. While the central bank does not need ROI in their investment or assets (can still function on a loss), the massive floating of the market with one’s own currency shouldn’t be taken lightly as it will slowly and surely erode the good faith and credibility of the central bank.