Uncle Larry is not an Economist, nor the Son of an Economist or the Grandson of an Economist. Nor is Uncle Larry the Seventh Son of the Seventh Son of an Economist. As a Junior Economist I heard it said recently the sole qualification to be a Senior Economist is to have a forecast that is close to being right once in a great while.

This piece that I am writing for your consideration is not meant to be a forecast but to share with you what I consider to be the single greatest issue of Domestic concern that faces our Bond and Stock markets – how it developed and what are the consequences of its intermediate future. This piece is educational in nature and because I am going to try to demonstrate how we got where we are it is much longer than my usual fare.

We are in uncharted waters. Does anyone know how many valiant and brave ship captains sailed west into the Atlantic from the Old World before Columbus actually completed the adventure? How many got just off shore and lost their bearings and ran aground – losing their ship and it’s lost souls. How many had a plan and good navigational skills only to be lost in a late summer Atlantic hurricane that they did not even know existed back in the safety and comfort of the Old World? I think that’s why they call it uncharted waters.

What/Who is my greatest concern? What plans have they set afoot that causes me such consternation? What have they done that could result in significant price declines in both the Bond and Equities Markets? Who is it that is also in “uncharted waters?” Your Federal Reserve System!

As the wise and ancient philosopher and one hit wonder Don McLean wrote – A long, long time ago, before any of us can remember – How the old Congress used to play! What game of chance did they play? They gave the keys to the financial Kingdom of the USA to the Federal Reserve System (The Fed) – virtually without restraint or supervision. In its infinite and so far proven wisdom – our Federal Government charged The Fed with the defense of our currency and banking system – which over time morphed itself into a Grand Fatherly role of protecting, massaging, restraining and stimulating our National Economy – as only a wise and North Eastern University educated Grand Father could.

Yet now in the age of paperless wonder our Grand Fathers at The Fed find themselves – by their very deliberate actions in uncharted waters. The results of which may turn into a well-managed National recovery with a “soft landing” – or may wreak havoc on the portfolios and life savings of Americans who are invested in either the bond or equities markets.

At this point please allow me to back up and review a few basics you probably already know.

The Fed has a Mandate to defend our currency, protect our Banking System, manage our National economy and control inflation – primarily on two broad fronts: Interest Rates and Money Supply. In layman’s terms The Fed can significantly influence the availability of credit and how much it costs. Stated more plainly The Fed works to control the amount of dollars available for lending, investment and savings and what those dollars will cost in terms of the interest rates charged.

What specific tools does The Fed have available to them to accomplish these goals? Their primary tools are:

1. Federal Funds Rate – The interest rate that banks lend money to each other on an over night basis. The interest rate or cost for many loans and derivative contracts are based on the Fed Funds Rate plus a specified margin.

2. Discount Rate – The interest rate The Fed charges banks to borrow from The Fed as the “lender of last resort.” While important, the Discount Rate is more symbolic than practical because the last thing a Bank wants to do is borrow from The Fed at the “Discount Window.” It’s a sure sign there is trouble afoot at the Bank and raises many eyebrows from Regulators and Investors alike.

3. Bank Reserve Requirements – A dollar amount, established by The Fed which the banks must leave at The Fed “on reserve.” Bank funds held on reserve at The Fed are dollars the banks can not lend so higher reserve rates reduce the dollars available for lending and vice-versa. Prior to 2013 The Fed paid no interest to the banks on their reserves – thus the banks desired lower reserves and The Fed higher ones. Now that The Fed has the ability to pay interest on reserves this gives them another tool in their box. They could, for example, encourage banks not to lend – potentially slowing economic activity – by paying a generous rate on Bank Reserves.

4. Money Supply – The amount of dollars that exist in the system and are available for lending (credit), investment and savings. This is a simple sentence but one of tremendous import. According to the laws of “supply and demand” the more there is of something the less it is worth and vice-versa. Unlike natural resources, such as gold or oil, which have limited supply – The Fed has the ability to create money at will. A process called “easing.” Like a Magician – one moment you can look and there is no money available – and in just a few short years The Fed has created Trillions of Dollars.

How does The Fed do this? Through the buying and or selling of bonds and other assets – primarily US Treasury Bonds and or US Government Agency (GSE)  Debt and or Mortgage Backed Securities (MBS). How does it work? Simple! If The Fed wants to increase the money supply – the available amount of credit – and in theory make credit cheaper and lower interest rates – ALL THE FED HAS TO DO IS BUY BONDS from banks and brokers. Where does The Fed get the money to pay for these bonds? Easy – they create it out of thin air – they “print it” – they snap their magic and quite legal fingers and the money appears out of no where and is put in the system – paid to the banks and brokers for the bonds and WALA – the money supply goes up – available credit goes up and interest rates go down. Again, this process is called “easing.”

How often does this happen? Every day!

How much money has The Fed Created this way? Only The Lord knows how much has been created over time. However, as of April 10, 2013 The Fed had 3.21 trillion dollars – $3,210,000,000,000 – of liabilities – a good gauge of Fed lending.  Will you please say that number with me again? $3.21 Trillion – $3,210,000,000,000!

To help you put it in perspective how many times have you heard that the Chinese hold so much of our debt that they practically own us. Please take a moment before reading on and guess how much UST debt the Chinese own. . . . . . . . $1.2 Trillion or $1,200,000,000,000. As of April 13th The Fed owned nearly two trillion of UST debt – far more than even the Chinese. Throw in the GSE Debt and MBS The Fed owns and you can see the big US Debt gun-slinger isn’t the Chinese – its our own Federal Reserve System.

Hold onto this thought because this is a problem and we will circle back to it after we address a few other moves The Fed has used in its tool box to stimulate the economy.

There are two major moves – tweaks to their tool box – The Fed has made in the past five years that have: (1) Increased the money supply and available credit significantly – (2) Lowered Interest Rates across the yield curve to historical lows and (3) Quadrupled the holdings of US Treasury and GSE debt (from approximately $800 billion to $3.2 Trillion).

They are known by people in the financial market as: The four Quantitative Easings and “The Twist.”

The Quantitative Easings – Known as QE 1, 2, 3 and 4 – were specific announcements made by The Fed that they were going to buy large amounts of UST and GSE debt. These announcements were made in Dec of 2008, November of 2010, September of 2012 and again in Dec of 2012. I give you these dates, not because they are important but to help give you the feel that these repeated actions by The Fed are more than just a “policy signal.” They led to specific monthly quotas of Debt purchases by The Fed that have increased their bond portfolio from less than $1 Trillion to over $3 Trillion.

The Twist – Having nothing to do with Chubby Checkers – was a deliberate reshaping of the maturity structure of The Fed’s portfolio. They sold shorter maturity debt and replaced it with longer maturity debt? Why is this important? They were already using their Fed Funds tool and QE to keep short-term interest rates low. By focusing their buying in the longer maturities this creates incredible demand for long-term debt (5 to 30 year maturities) – which had the intended result of lowering long-term interest rates – creating what the financial markets call a “flat yield curve.” At present The Fed owns approximately 40% of all outstanding long term UST Debt.

What is their motivation? To keep long-term borrowing costs low – mortgage lending being a prime example. In general the average 30 year amortizing mortgage loan “costs” or bears an interest rate of approximately one and a half percent (1.5% or 150 basis points) over the Ten Year UST yield. If the Ten Year UST yields around two percent – thirty year mortgages will cost about three and a half percent (2% + 1.5% = 3.5%). Relative to mortgage rates in the late twentieth and twenty-first century these are historically low mortgage rates and The Fed hopes this will both support and stimulate the housing market.

By now you are probably tired, bored or asleep so let me move to what as I see as the problem at hand.

None of the things we have reviewed and learned about in and of themselves are bad. In fact The Fed has achieved its goals, kept interest rates low and money available for lending and mercifully our economy is responding to this massive inflow of cheap and plentiful money – without any significant inflation issues to date.

What then has Uncle Larry concerned? I would like to borrow an illustration I learned decades ago from my friend and a real Economist, Brian Wesbury. Think for a moment that you are in South Florida where it is warm and sunny and you are in your back yard pool. Someone tosses you a big beach ball and you push it down and down and soon you are holding it under water. It only requires a modicum of strength to get it under water but you decide to keep the ball submerged for a long time. That requires considerably more and continuous strength.

What happens when you decide the time is right to let the ball go? The ball pops up out of the water and into the air. That seems like fun so you hold the ball under water a second time – holding it much lower and then you let it go. What happens? The ball pops up faster and goes even higher than before!

Brian’s illustration paints a true picture of the uncharted water The Fed and our Financial System are in. They have been holding interests low for a long time. It has taken a considerable effort on The Fed’s part to get and keep interest rates low. What is going to happen when The Fed decides it’s time to let go? How high will the ball of interest rates go? More importantly in my view how fast will the ball of interest rates come flying out of the water? Will individual investors like you and I have time to react – adjusting our investment portfolios before we lose our shirts in both our bond and equity holdings?

Wait just a minute there Uncle Larry! When interest rates go up won’t that be a sign the economy is doing better and my stock prices will go up and your bond prices go down? I don’t think so! If the ball moves up as fast as I fear it can – uncertainty will grip the equity markets and they will fall dramatically in price along with bond prices – a double whammy for “buy and hold” investors like myself.

Why does Uncle Larry think bond prices will fall and fall quickly? As the old saying goes “this ain’t your father’s bond market.” When – not if – but when The Fed Chairman signals any move that The Fed is done buying UST and GSE (bonds) it’s possible the collective genius of the bond markets will interpret that signal to mean the next step will be the selling of some or a good portion of the massive amount of bonds in The Fed’s portfolio (over $3 Trillion remember).

There’s an old saying in the bond business. When you’re a “buyer” everyone is your friend. When you’re a “seller” your phone never rings.

Bonds are like a commodity. You don’t have to own them to sell them. You can sell bonds “short” just like gold, oil, stocks or any commodity with an organized market. In my opinion professional investors, hedge/leveraged fund managers, portfolio managers involved in hedging activity, mutual funds and even more dangerously – speculators like George Soros and the like who don’t care about anything but making a quick buck will sell the UST bond market short and the shorts will lead the way to what could be a significant decline in the bond markets.

Big money professionals could be climbing over themselves shorting both bonds and stocks like a drunken, crazed mob at a rave party – all trying to get out the one open door when they “think” they hear the fire alarm going off. In my view the alarm doesn’t actually have to go off – the professionals and speculators only have to think it is going to go off some time in the near future and its “Katie bar the door” with unwelcome results for all us buy and hold investors.

Is there a chance this won’t happen? Sure and I may lose fifty pounds, get down to a 32 inch waist, grow a full head of hair and go on the Champion’s Golf Tour and play with Fred, Jack and the boys.

Seriously there are mitigating factors and when I get in a more positive frame of mind I will work on another Blog Post and share them with you. But for now this Post has become too long but I do hope you learned something from it and are not as concerned as I am.

Uncle Larry