The Fed's Quant Easing Gameplan

I as well as many other Fed watchers was taken aback by the lack of aggressiveness on the Fed's meeting on 4/29, not only because I was long some 30 year treasury calls, but because the present deluge of treasury supply may not be met at these rate levels without more aggressive treasury buying. I am now no longer sure the Fed is planning on targeting money supply expansion going forward primarily via treasury purchases. This may be a tell to their long term game plan.

Right now, in the most simplified manner, the Fed is pursuing a dual-pronged attack of quantitative easing. The first being through Agency MBS purchases - $1250B committed, $450B likely used up so far; the second being outright treasury buying.

Here we see the effects of reactionary policy. The crisis related rotational movement of foreign central bank reserves from agencies to treasuries of similar maturity is obvious. The December short squeeze on the thirty year bond was likely mostly due to this.

Right now, the spread between the 30 year treasury and the 30 year mortgage rate is at all time lows, 40 basis points as I write this (4.05 vs 4.45 on the mortgage). Regardless of the recent 10-30 year US treasury weakness, mortgage yields are hanging low. This is entirely the handiwork of the Fed's appointed managers of the MBS purchase program, a direct result of targeted quantitative easing.

The Bottom Line: Is the Fed telegraphing their exit strategy?

In the face of a contentious treasury market threatening to drive rates far past the 3% 10 year line, and lack of aggressive treasury QE movement at the April 29th Fed meeting then today's open market operation where only 3B of 10+ year maturity treasuries were purchased, it isn't clear that the Fed is ready to commit to expanding money supply more than previously laid out. This could be for a myriad of reasons: desire to maintain Fed autonomy from congressional tinkering, or merely saving ammunition for what nastiness may remain in this recession.

It seems counterintuitive for the Fed to wait until rates go much higher to start buying treasuries again, as one might suppose they might get more low yield for their money if they buy while the market is already up at these levels. Waiting until 5% on the 30 year will likely make buying treasuries back to 4% more expensive than if they had just announced and supported a 3-4% target, teaching the market to do the brunt of maintaining the higher price on bonds.

Something else entirely might be going on. As we've seen, during this crisis the Fed has been very supportive of creating alternative measures to support credit. Fed funds are at record spreads to real borrowing costs for corporations. Banks benefit. Mortgage rates are touching record lows daily. Home borrowers as well as banks benefit (from refinancing streams making mortgages whole, and associated lower default rates). But what is missing is every other borrower is left out. Corporations' funding costs are directly tied to the treasury market, not the agency mortgageback security market. This benefits banks, while minimizing any stimulative effect all of this new monetary policy has. Borrow short, lend long - only banks are accommodated here.

This timid treasury buying, especially in the face of several trillion dollars of bailout-funding supply (the workings of fiscal policy), looks like an effort to intentionally not delay the refunding of bank balance sheets. While we may need more, not less, money supply now, the Fed may be targeting the credit multiplier rather than base money. Treasury quantitative easing would benefit base money, but might inhibit recovery of the credit multiplier. On the flip side, mortgageback quantitative easing targets the root of all of our problems, lack of available cheap capital to bid up houses. In the end, higher housing prices translates to increased bank solvency (and thus higher credit multiplier).

Doing the bulk of quantitative easing through agency mortgageback security purchases does provide another additional benefit. If inflation is to ever get out of control, despite consensus view that treasuries are much more liquid than agency MBS and easier to unwind in a tightening enviroment, there is a flip side benefit to liquidating a trillion dollar MBS portfolio in a contractionary policy environment: the Fed can do this without blowing up corporate funding costs. The future tightening will only shoot the housing market, a hopefully more resilient one. It might not be the worst bet to make that in a more highly regulated and less bubble like housing environment several years from now (where there is no subprime or option-ARM shoe to drop), sending mortgage yields to 8-10% (via liquidation of the Fed's MBS assets) might be something the housing market will eventually be able to endure without catastrophic consequence. With all of this going on, the nonresidential housing part of the real economy will not have to take a hit in its credit costs. Or at least, not as bad of one. This exit plan mutes the intensity of our post-recovery recessionary cycle.

What about the crowding out effect? If the US treasury is to sell several trillion dollars of treasuries in the next few years to fund its economic recovery without substantially increasing the money supply, there might not be much money left for corporate investment. The private sector, the most productive part of our economy, may lag and inhibit the strength of the ensuing recovery. On the other hand, this postulation is not quantitative. As discussed above, a longer run increase in the banking credit multiplier component of money supply in combination with the 1.25T of new money from the MBS quantitative easing may be more than enough to override the crowding out problem.

Conclusion: The Fed may not defend any interest rate level in the treasury market, might just be saving ammunition for later in the crisis, or this is more about playing politics and maintaining Fed sovereignty than what is actually best for the world economy. It isn't clear, but achieving bank system recapitalization in the most subversive manner possible is a difficult thing to do without bring about unintended consequences.

In this case, we may see a more dramatically bifurcated interest rate environment: mortgages rates lower than treasuries of equal maturity, with clear winners and losers as laid out above. In the long run, a larger bank credit multiplier (derived from a more profitable yield curve from high treasury yields) is where the Fed will get its best bang for the buck. Paradoxically, higher treasury yields resulting from lack of sufficient treasury-based QE (thus higher corporate funding costs) may actually inhibit bank lending, as a less stimulated economy might yield fewer credit worthy corporate (and thus private) borrowers. If the Fed continues to lag in long term treasury purchases several months out, that may be confirmation that these ideas are the actual plan.

Comments

[Clive Corcoran:]

A good analysis but it highlights that we are moving into uncharted territory where all kinds of accidents and misjudgments might result from these new policies

May 01 05:05 AM

[gabe borens...:]

What makes the FED policy very effective is the inability of the "traders" and others to " read"the FED's blue print.We have heard a nonsense about the band on the 10 year treasuries between 3% -3.10% .Now we are subjected to another "waste of time " analysis.Basically the FED in cooperation with "others" has deflected a decompressionary Armageddon as consensus was "babbling" about Depression.The policy in place is so effective that the U.S economy is about to explode to the upside.All the FED is doing(most likely) is trying to fine tune policy in order to maintain various "forces " in check. I would not worry about "crowding out" effect as the Central Banks are substantial investors in the treasury sector and the dollar is about to replace gold as the ultimate and liquid asset. One thing for sure the less details the FED divulges to the market ,the more effective its' policies will become.You want to know about FED's long term objectives ,interview Mr.Bernanke -although I doubt that he would divulge this info-any other analysis is useless-although the FED did avert another turmoil and for that they should receive a lot of praise.
The FED came from behind the curve and now effectively they are ahead of the curve and very effective.

May 01 09:44 AM

[Prudent Man...:]

Q.E. = P.C for print money!

The BHO Administration likes to change names as if that is going to change outcomes. It is going to be a good show when realities are realized. Of course, the names will be changed to protect the innocent.

Top Secret Documents are what? Put the country in harms way so a few statists can "feelgood". When this craziness is realized, as they cannot paper it over with deficit spending for long as the numbers are extraordinary, the "Fat Lady Will Sing!".

The "Black Swan" is a Treasury Auction and China doesn't come. Do we really want to depend upon people who don't like us to finance our reckless spending?

May 01 10:00 AM

[Market Sniper:]

Good old "quantitative easing". Another word for the direct monetization of debt. Watch the cover ratios on debt offering. When they drop to 1.0 and then below, the Treasury will have a number of options: 1) Withdraw unsubscribed debt and reduce spending accordingly. NOT going to happen; 2) re-offer unsubscribed debt at a higher rate. HIGHLY unlikely as it could touch off an interest rate spiral to the upside or 3) trot the unsubscribed debt across the street to the FED who will obligingly issue "money" for it. This is an unmitigated disaster in the making. There is not enough willing capital on the planet to cover US Treasury debt offerings that will only mount higher in the future. As Treasury receipts continue to drop due to fewer taxes being collected and as the amount of debt skyrockets, how long will it take before the bond vigilantes mount up? China has already said thank you but no thank you to an increase in their purchase of US debt. Indeed, their future levels of participation will doubtlessly dwindle as debt is rolled over on top of new debt being created. this leads to the very likely potential of a hyper-inflation and currency collapse. It is becoming more clear by the day that the specter of Weimar now stalks the land. This is a very old, old experiment we are trying here and at no time in history has it ever worked out well. Yes, this time it is different. This time it is world wide as various governments are all in a race to see who's currency goes to zero first. Looks like Zimbabwe has already come in first in that race. Who will come in second?

May 01 12:47 PM

[Jason Rines...:]

Oh hi Gabe. After I scolded you for giving horrid predictive economic advice which I was 100% correct and your were 100% wrong, you come back with blanket forecast about how the economy is about to ROAR back to life. Commodities should do OK in a few months, just like 1935-1937. Yes, most sector boats will be lifted for a short time. But to promote economic 'bliss' is absurd. You will be wrong AGAIN. Let me know if I should post our previous discussions from 2008 on this post. I am going to hear crickets on that one.

> The policyin place is so effective that the U.S economy is about to explode
> to the upside.

May 01 04:28 PM

[pussum207:]

"This timid treasury buying, especially in the face of several trillion dollars of bailout-funding supply (the workings of fiscal policy), looks like an effort to intentionally not delay the refunding of bank balance sheets. While we may need more, not less, money supply now, the Fed may be targeting the credit multiplier rather than base money. Treasury quantitative easing would benefit base money, but might inhibit recovery of the credit multiplier."

Excellent, excellent point.

May 01 05:30 PM

[altaman:]

Blah blah blah. I think you miss the fact that whatever manipulations the BO administration tries, regardless of their cleverness, motivation or purpose, cannot prevent the markets from discounting the debauching of the dollar and a blizzard of Treasury supply by requiring a higher risk premium. The bill will come due subtly, in form of gradual destruction of savings and purchasing power by inflation, and unsubtly in the form of crushing taxes. The sheep are still enjoying what they think is a free lunch and so they must be further shorn.

May 01 07:33 PM