Bond Expert Wednesday Outlook: Awaiting the Fed

Prices of Treasury coupon securities have drifted modestly lower in overnight trading as traders wait with bated breath for the potentially market moving events of today.

In the first instance, Timothy Geithner and his minions will auction $40 billion 5 year notes. That is the largest batch of 5 year notes offered to humanity since the dawn of time. I suspect that the issue will garner a larger curve concession and outright concession than exists at the moment. If one bids and buys these things at 1:00 PM, there is not much time to exit the trade in advance of the conclusion of the FOMC meeting.

So buying these securities on the blind without knowing the nuanced body language of Federal Reserve policy (which will be available at 2:15 PM with the release of the statement) could cause serious damage to dealer P and L.

I think in advance of the auction, caution will be the byword and the taxpayers will pay the price as bonds come cheaper.

As I noted, the FOMC meeting will dominate trading activity as participants await the proclamation of policy at about 2:15 PM.

It is easy to conclude that the FOMC will upgrade its view of the US economy. The Chairman recently averred publicly that the recession is “technically” over. As the members meet and review the economic data released since they last convened, they will conclude that the economy is far from robust or healthy but is unabashedly less bad than when they gathered in August.

Payroll growth remains negative and the unemployment rate is higher. But on the payroll side the pace of declines has slowed.

Manufacturing has improved, also. The various surveys of manufacturing have showed some resiliency and capacity utilization has improved.

The various surveys of consumer confidence manifest a less pessimistic consumer and there is evidence of stability of sorts in the housing market.

Consequently, the Committee will be slightly more sanguine in its description of growth.

I think they will note that inflation will not be a problem for the rest of our natural lives (and possibly even into our supernatural lives).

I think that the Committee will also address the program by which it purchases MBS and direct obligations of GSEs. In my opinion, they will reiterate the plan to buy a total of $1.450 trillion of that paper. I think that there is a chance that they will do what they did with the Treasury program and slow down purchases and extend the program into Q1 2010.

The key point of the statement will be the recitation of the phrase that the federal funds rate will remain low for an “extended” period of time. While a strong case can be made that the bottom is in place, it is impossible to conclude that a robust recovery has begun. I think the Committee will recognize that and leave the promise of cheap financing in place.

That leads to a discussion regarding reverse repo by the Federal Reserve. In my day we called reverse repo by the Federal Reserve “matched sales”. This was not an incendiary device but was a tool by which the Federal Reserve drained reserves from the banking system.

The Open Market Desk would sell a Treasury bill (or sometimes several bills) from its portfolio and would promise to buy it back the next day. Once in a while they would do this for longer periods but generally it was an overnight transaction. The selling price was some approximation of the daily repo rate and the dealer community would often compare that rate to the funds rate and the repo rate to draw some conclusion about monetary policy.

Often times the action was motivated by seasonal reserve flows and had no policy significance but it was often difficult to convince participants of that.

The salient point is that match sales withdraw liquidity from the system and, ceteris paribus, will lead to higher short term rates.

The exercise was the principal tool of the Desk when the Fed was in tightening mode.

So my problem is that reverse repo by the Open Market Desk (matched sales) is inconsistent with the statement that the financing will be cheap for an “extended” period of time. Massive matched sales done for term will lead to higher short term rates unless the Fed does something to offset the impact. In which case, why do them at all?

I had a conversation with economist Kevin Logan the other day. He was the economist at Dresdner during my stint at that firm. We discussed various aspects of Federal Reserve policy. I do not think I misstate his opinion when I note that he thought the discussions regarding reverse repo were preliminary and were meant to iron out operational issues.

The increase in the size of the Fed’s balance sheet has been massive and when the unwind begins the withdrawal of liquidity will be larger than anything ever witnessed before. I think that the Federal Reserve and the dealer community understand that and wish to make sure that procedures and operational policies are in place such that when the process begins it will be efficient and somewhat seamless.

However, in the short run matched sales or reverse repos are inconsistent with low funds rate.

The yield on the two year note has climbed 2 basis points to 1.03 percent. The yield on the three year note has increased 2 basis points to 1.54 percent. The yield on the five year note has increased 3 basis points to 2.44 percent. The yield on the seven year note has jumped 3 basis points higher to 3.10 percent. The yield on the ten year note has increased 2 basis points to 3.47 percent. The yield on the thirty year bond has climbed 2 basis points to 4.22 percent.

The 10 year/30 year spread is 75 basis points.

The 2 year/10 year year spread is 243 basis points. It is narrower because of the forward roll on the new 2 year note.

Comments

[LKofEnglish:]

Reverse repos. Hmmm. At what point is the rumor recognized as reality?

Sep 23 08:34 AM

[Tony Petroski:]

Fascinating bond talk as always.

"Every eye fixed itself upon him; with parted lips and bated breath the audience hung upon his words, taking no note of time, rapt in the ghastly fascinations of the tale."

Sep 23 09:49 AM

[Mad Hedge F...:]

xcv Reviewing the current political and monetary landscape, I would be remiss, irresponsible, even negligent, if I didn’t revisit one of my favorite ETF’s, the Proshares Ultra Short Treasury Trust (TBT). This is the 200% leveraged bet that long Treasury bonds, the world’s most overvalued asset, are going to go down. While the Fed is going to keep short rates low for the indefinite future, it has absolutely no direct control over long rates. The only political certainty we can count on it the continued exponential growth in the supply of government bonds of all maturities. Like all Ponzi schemes, their eventual collapse is just a matter of time. It’s simple a question of how many greater fools are out there (sorry China). Look at how they are trading now. We currently have the greatest liquidity driven market of all time, and the ten year is only eking out a 3.40% yield, pricing in near zero inflationary expectations. The average yield on this paper for the last ten years is 6.20%, a double from the current level. Get the yield back up to 5%, a distinct possibility in 2010, and that takes the TBT from the current $45 to $70. Sure we may get a sideways grind in yields for a few months, which will be expensive due to the mathematic idiosyncrasies of the 2X ETFS. But a security that is unchanged if I am wrong, and doubles if I am right is the kind of risk/reward ratio that I will take all day. And I believe that in my lifetime Treasuries may lose their vaunted triple “A” rating and be priced closer to subprime (warning: I am old). That could enable the TBT to deliver the holy grail of trades, your proverbial ten bagger.

Sep 23 02:09 PM