How the Fed Produced the Fiscal Cliff and Raised Your Portfolio Risk

If it weren’t for the monetary policy of the Federal Reserve governors and Fed Chairman Ben Bernanke, there would be no fiscal cliff. Of that I'm convinced. 

I say that because the Fed is the great enabler. It is the proverbial drug pusher; the supplier of the “dope” – free money – that allows the D.C. politicians to spend extravagantly, while avoiding the consequences of their extravagance. 

Their symbiotic relationship is as simple as it is addicting. 

The U.S. Treasury issues bonds, notes and bills to cover the deficit between spending and taxes received. Thanks to the Feds voracious appetite for these securities (the Fed bought nearly 70% of Treasury's debt this year), an artificial demand is created, which lowers the required yield, and thus the Treasury's borrowing costs. (In addition, all profits the Fed generates are returned to the U.S. Treasury.)

While total government debt has ballooned in recent years to nearly 100% of gross domestic product (GDP), the annual interest paid by the government on the debt has remained constant.  Interest payments remain manageable because of falling interest rates. In 2001, the federal government paid an average of 6.2% on its debt. The average rate today is around 2%.

This is a useful alchemy for a free-spending Congress: jack up the debt level but not the annual interest paid on the debt. 

The politicians, in turn, can continue spending and avoiding the hard choices the fiscal cliff demands. Instead of lowering the heightened level of uncertainty that plagues financial markets, the politicians can prolong it by continually raising the debt ceiling. 

In the meantime, business continues to languish. U.S. companies sit on record levels of cash (approximately $2 trillion). They are unsure what markets to pursue or where to invest because they are unsure how any eventual compromise on the fiscal cliff will impact their plans.

This stockpiling of cash is a drag on the economy, because cash does not earn a real risk-adjusted return. Investment fuels economic growth, not cash. 

The Fed's monetary policies have produced a nightmare situation for income investors: The 10-year Treasury note yields 1.7%, a high-grade municipal bond yields 1.5%, one-year certificates of deposit yields less than 1% and pass-book savings and Treasury bills yield a few basis points. 

None of these investments provide a positive real rate of return when taking inflation into account. 

In desperation, many investors have turned to Treasury Inflation-Protected Securities (TIPS), believing these investments will protect their income against inflation and interest-rate risk.  

Unfortunately, they're wrong. Investors have been fooled into believing TIPS will help maintain purchasing power. TIPS won't, because they have been manipulated to understate inflation. The Fed also buys TIPS and, thereby distorting the important inflation gauges in the market.  

In the search for yield and income, many investors have doubled down by seeking out longer-maturity and riskier bonds. This is a dangerous strategy, because the longer the average maturity of a bond portfolio, the greater the interest-rate risk (i.e., the risk that the bonds fall in value as interest rates rise).

We need only look back to earlier this year when a few encouraging economic indicators persuaded investors that the economic recovery was finally under way. That wasn't the case, and the bond market sold off sharply. Many investors suffered significant losses.