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The Federal Reserve is breaking all kinds of records these days. Its balance sheet has swelled to more than $2.9 trillion and will reach new highs in 2013, as the Fed purchases $85 billion a month in Treasury and mortgage-backed bonds.

The growth of its holdings in turn is causing the central bank to remit record amounts to the U.S. Treasury. On Thursday, the Fed said it sent $89 billion back to the government in 2012, the highest ever. It is a strangely circular arrangement: The government pays interest to the Fed, and then the Fed pays it back to the government.

Of course, the current record isn’t likely to last long. The Fed’s balance sheet could swell to nearly $4 trillion by the end of this year. If the Fed generates a return similar to that of 2012, next year’s payout could easily top $100 billion.

For now, that lowers the government’s net interest cost—over the past four years, the Fed has remitted nearly $300 billion. When it comes time to wean the government off this, though, expect some tears.

That passage is from today’s Wall Street Journal. In a nut shell, the Treasury borrows money buy issuing bonds. The Federal Reserve Bank then buys these bonds paying cash to the Treasury which is used to fund the government. Then the Treasury pays interest to the Fed and then the Fed kicks that interest back to the Treasury. Speaking of nut shells, this sounds like a shell game if I’ve ever heard of one.

So what’s the point of all this? The Fed started buying Treasury Bonds in the midst of the financial crisis to suppress long-term interest rates (the Fed is really only capable of controlling short-term rates otherwise). The Fed believes that low, long-term interest rates are in the best interest of the nation’s economy but this is not a debate for today’s post. What I’m interested in examining today is the Fed’s role in the financial markets. The Fed is now buying mortgage securities in addition to Treasuries in order to suppress the interest rates on home loans, as well. These are very drastic measures that Fed Chairman Ben Bernanke insists were necessary to prevent another Great Depression.

I don’t disagree with him but I still worry about their eventual cost. What if the economy were to dip back into recession over the next year or so? What would the Fed do in addition to its current programs in order to support a weakening economy? Some have said the Fed could start buying stocks. They could also just ramp up their current programs by buying more Treasuries and mortgage securities. The problem is that they’ve already levered the balance sheet to the moon over the past few years. How long before our Federal Reserve Bank needs a bailout? Talk about ‘too big to fail!’

Don’t worry. The Fed will never need a bailout. The Fed is in control of the country’s electronic printing press (the Treasury, on the other hand, prints and mints our hard currency) and can create money out of thin air. In fact, that’s exactly how they have been paying for all the securities they have been buying over the past few years. So, perhaps the better question is not “how long can they continue to do this?” but “how long before people lose confidence in our nation’s currency and financial status?”

I think this is a reasonable question every investor needs to ask. The Fed’s past “quantitative easing” campaigns, in which they buy public securities to reduce rates and boost asset prices, have all generated gains in risk assets. I don’t what part of the gains are due to the Fed’s actions and what part are due to natural economic factors but there’s no denying the Fed has had a positive impact. Each of these campaigns has had a more muted effect than the last and it’s made me wonder ‘what happens if the Fed introduces a new program that simply doesn’t have any positive effect on risk assets?’ This is what folks mean when they say ‘the Fed will run out of ammunition.’ Their activities just won’t inspire investors to follow in their footsteps.

I believe that should the markets fail to be stimulated by Ben Bernanke & Co. at some point in the future investors would panic. Because if the Fed can’t save us then who can?

I don’t know what odds to put on this kind of a scenario but investors should try to answer that for themselves and then decide how well-prepared they are should it occur. Gold may act as an insurance policy against just this kind of occurrence. Not just gold, all real assets that Fed is unable to manufacture would be ideal holdings. If the world were to ever come to the conclusion that dollars were a fraud they would scramble to exchange them for anything that can’t be debased or devalued.

The odds of something like this actually happening are probably pretty small but they’re growing every time the Fed buys more securities and expands its balance sheet. And the odds of some, smaller form of this scenario occuring are higher than those of a full-blown run on the currency. For this reason I think it makes perfect sense to focus a portion of your investment portfolio on things that are real: real estate (SCHH), precious metals (GLD, SLV), commodities (DBC), etc.

Chart of the Day

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Speaking of commodities, the downtrend that started in early 2011 was broken last summer. The index then tested the break and now looks poised to start another run higher.

Hit the Links

  • This week, investors staged one of the biggest moves into stocks of all time. (Business Insider)
  • Sentiment Screams Stocks Should Soar not Sink (Dragonfly)
  • Ten reasons why doing good is good for your business (The Globe and Mail)
  • Apple executive dismisses cheaper phone as a market share grab (Reuters)
  • The cheap iPhone is already here, if Americans can do the math (Quartz)