Goldman Sachs Versus the Fed

by Jeff Speakes on February 20th, 2013
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At the recent World Economic Forum in Davos, Goldman Sachs Chief Operating Officer (COO) Gary Cohn suggested that many investors and banks might not be prepared for what he called a “significant repricing” in bond markets.  What he means by “significant repricing” is that bond yields may spike higher and bond prices fall dramatically.  His boss, Goldman CEO Lloyd Blankfein said at a recent conference that the risk of a bond market crash is growing, and that many investors seem to be unprepared for this.  Meanwhile, Goldman Sachs is getting prepared.  They have dramatically reduced their exposure to rising rates by shortening the duration of their assets and lengthening the duration of their liabilities.  Goldman does not refer to such positioning as proprietary trading, they are simply adjusting their risk exposures.

What can you do to mitigate the risk of rising interest rates?  Just like Goldman, you can sell long-term bonds and invest in shorter term bonds or simply hold cash.  And you can issue long-term debt (like fixed rate mortgage debt) and pay off short-term consumer debt (like credit cards).  So long as interest rates remain very low, the cost of this strategy is that you will earn a lower return on your assets. 

One giant market participant that is doing exactly the opposite of the Goldman Sachs strategy is the Federal Reserve.  In Operation Twist they are buying long duration securities (Treasury bonds and MBS) and selling shorter term securities.  So long as rates stay low, the Fed is the most profitable entity on the planet.  Last year Federal Reserve income was $91 billion, mostly from positive net interest income on their $3 trillion balance sheet.  The vast bulk of this income, approximately $89 billion, was turned over to the Treasury to reduce Treasury borrowing by a like amount.  If interest rates were to rise sharply, this could hurt Fed income in several ways.  First, there would be mark-to-market losses on their vast securities holdings.  Under market value accounting rules, banks and other financial institutions are required to show these market value losses as accounting losses as well.  It appears that the Fed does not have to follow this accounting rule.   Second, if rising interest rates is associated with stronger growth and the desire of the Fed to reduce its holdings of securities, then the Fed must sell the securities and recognize the market value losses.  Third, so long as the Fed continues to pay on reserves, rising short-term rates mean higher cost of funds and potentially negative net interest income.  Not to worry, however, because the Fed sets its own accounting standards.  And in a change made in February 2011, any losses experienced by the Fed will not reduce capital, but will instead be recorded as a “deferred asset,” effectively a reduction in the interest to be paid to the Treasury.

It seems a little strange to contemplate the Federal Reserve being exposed to interest rate movements, given that it is widely believed that the Fed controls interest rates.  If rising rates hurts the Fed, then why not just keep them low?  The problem arises if and when inflation begins to take off.  In a rising inflation environment, Federal Reserve attempts to keep rates low has the paradoxical impact of pushing inflation and nominal interest rates higher.

It is generally agreed that inflation and interest rates will rise, eventually.  But most market participants believe this will not occur in the near term.  The Japanese experience over the past twenty years or so suggests that periods of very low interest rates can extend for long periods.  But it appears that Goldman Sachs does not share the consensus view that rates will remain low in the near term.  Don’t forget that Goldman was the one major bank that successfully hedged itself against the mortgage collapse of 2007-2008.  They did this by taking short positions in derivatives that were tied to mortgage credit risk.

And today the company is taking steps to lessen or eliminate rising rate exposure.  This suggests that executives place substantial probability on a near-term bond market event (price collapse, yield spike).  Clearly, they are at odds with the consensus forecast and the Fed forecast (the latest FOMC statement repeats the assertion that the Committee expects short-term interest rates to remain low through 2014).  It is will very interesting to see who has made the better market call.

If Goldman turns out to be correct, this will be a little embarrassing for the Fed, but it will be more than embarrassing for investors and financial institutions that fail to take precautions against rising rates.  One feature of bond market mathematics that is often overlooked is that the sensitivity of bond prices to interest rates is greater when market rates are lower.  As interest rates have continued to fall, this has created larger and larger capital gains for owners of long-term bonds.  But, when interest rates start to move back up, owners of long-term bonds will experience large capital losses.  And, unlike the Fed, other financial institutions do not have the luxury of creating a “deferred asset” to absorb these losses.

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