PowerSwitch

A new paper for the US Monetary Policy Forum and published by the Fed warns that the institution's capital base could be wiped out "several times" once borrowing costs start to rise in earnest.

A mere whiff of inflation or more likely stagflation would cause a bond market rout, leaving the Fed nursing escalating losses on its $2.9 trillion holdings. This portfolio is rising by $85bn each month under QE3. The longer it goes on, the greater the risk. Exit will become much harder by 2014.

Such losses would lead to a political storm on Capitol Hill and risk a crisis of confidence. The paper -- "Crunch Time: Fiscal Crises and the Role of Monetary Policy" -- is co-written by former Fed governor Frederic Mishkin, Ben Bernanke's former right-hand man.

It argues the Fed is acutely vulnerable because it has stretched the average maturity of its bond holdings to 11 years, and the longer the date, the bigger the losses when yields rise. The Bank of Japan has kept below three years.

Trouble could start by mid-decade and then compound at an alarming pace, with yields spiking up to double-digit rates by the late 2020s. By then Fed will be forced to finance spending to avert the greater evil of default."Sovereign risk remains alive and well in the U.S, and could intensify. Feedback effects of higher rates can lead to a more dramatic deterioration in long-run debt sustainability in the US than is captured in official estimates," it said.

The Precarious Balance Continues

Almost 70 years later, the global monetary system is still living in the long shadow of Bretton Woods. Triffin’s views are as relevant today as they were when they were first published more than half a century ago. The current paradox in the global monetary system is as unsustainable as it was under the original Bretton Woods Agreement. The exact timing of an inflection point for Bretton Woods II remains unclear, and although it is not imminent, its eventual occurrence is virtually certain. As was the case in the 1960s, a reversal of the acquisition of Treasuries by foreign central banks will cause a major shift in global capital flows and insecurity about the value of dollar-based assets, particularly Treasuries.

The most likely outcome will be renewed support for precious metal, which functions as a store of value and a hedge against currency depreciation. In contrast to the 1960s, bullion is free to float at market prices and gold markets have already begun discounting a future set of circumstances which is much different from today. The time to buy insurance on the end of Bretton Woods II is before the inevitable occurs.

None of this should come as a surprise given the unorthodox growth of central bank balance sheets around the world. The collapse of Bretton Woods in 1971 caused a decade of economic malaise and negative real returns for financial assets. Can anyone afford to wait to find out whether this time will be different?