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What a day in the bond market and on Wall St. Stocks gyrated like a roller coaster today as the Fed announced some dramatic changes when it comes to its balance sheet.

Essentially the Fed announced that it plans to start buying treasuries using the principal payments it earns from their $1+ trillion dollar MBS (mortgage backed securities) holdings. Here are the details from the New York Fed:

On August 10, 2010, the Federal Open Market Committee directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities (agency MBS) in longer-term Treasury securities. The most recent H.4.1 data release indicates that outright holdings of domestic securities in the System Open Market Account (SOMA) totaled $2.054 trillion as of August 4, 2010. The Desk will seek to maintain the face value of outright holdings of domestic securities in the SOMA at approximately this level. Due to differences in settlement dates for purchases and principal payments, it is anticipated that the actual level of domestic securities held will vary around this level to some degree.

Quick Take

Sounds like a win-win for the Fed, right? The Fed kept its balance sheet the same size, and also kept Wall St. happy by announcing more treasury purchases.

The problem here is this little sentence that at the bottom of the NY Fed piece above:

"The Desk will concentrate its purchases in the 2- to 10-year sector of the nominal Treasury curve, although purchases will occur across the nominal Treasury coupon and TIPS yield curves. The Desk will typically refrain from purchasing securities for which there is heightened demand or of which the SOMA already holds large concentrations."

Needless to say the bond market wasn't happy about where the buying will take place when it came to the 30 yearbond. Yields on the 30 year soared higher after the initial drop following the easing news out of the Fed [click to enlarge]:

Check out Bill Gross's take on this at around the 12:14 mark of the video below. He pretty much confirms where the buying will likely take place and why:

My Take:

As you can see Bill believes the majority of the treasury purchases will be in the 5yr and 10 yr maturities.

The Fed wants to stay away from the 30 year according to Gross because it knows that ity will be expanding its balance sheet which will be reflationary, not deflationary.

The 30 year bond is a deflationary trade. This all but assures you that we will be seeing another QE from the Fed. The Fed doesn't want to own 30 year bonds because they are going to fall in value when its balance sheet expands as the next batch of money is dropped out of helicopters. This reflationary move will then force people out of the 30 year because they are going to drop in value over the longer term when this reflation takes place.

By avoiding the 30 year (due to the fear of losses as they reflate), the Fed has created a serious distortion in the bond market. This is not good, because markets hate uncertainty. That sell off in the 30 year Tuesday following the news was flat out violent. What's even more interesting here is that we have $60 billion in 30 year bond auctions this week.

We could see some really bad bids to cover ratios on these auctions. However, I also wouldn't be surprised if they went smoothly as the Fed makes sure the Primary Dealers have this week's sales covered as they attempt to tie a pretty bow on top of the bond market following their announcement.

Over the longer term the 30 year is in trouble. Why would you want to own these when the Fed is avoiding them?

The Bottom Line

Tuesday was an extremely important day. The Fed has backed itself into a corner. Investors are now going to pile into the 2-10 year area of the bond curve in an attempt to front run the Fed. The 3yr auction saw record bidding.

The problems with Tuesday's announcement are multifaceted. Here are the questions that I have:

  • What happens if there is a run on the 30 year?
  • What happens to our currency as the Fed continues to print money? The dollar tanked on the news.
  • What happens to MBS now that the Fed is abandoning this market and continues to invest the principal into treasuries?
  • Who is going to buy the newer MBS issuance if the Fed plans to focus on treasuries instead of MBS?
  • What will this do to interest rates?

I will end it there. Expect some serious unintended consequences from Tuesday's policy shift. We already saw one with the move in the 30 year.

Folks, you need to seriously ask yourself why the Fed decided to pile into treasuries when rates are at all time lows. I mean what is the point? It's not as if this is going to push rates much lower.

The only conclusion I can make is they are running short on demand from the rest of the world. China announced Tuesday morning that it is having troubles with its banks. We also got news that its imports slumped. Perhaps its reserves are going to be spent fixing these problems instead of piling into our treasury market.

Mark this day in your calendar. The Fed piled into treasuries for a reason and in my eyes it's a desperation move when you look at how low yields already are. If the demand for treasuries is weakening then we are in deep trouble. As I said Monday, it will keep easing in order to keep the status quo. However, it's clear it is running out of options.

Tuesday's move just took us one step closer to the day of reckoning that cannot be avoided at this point.

Disclosure:
No new positions held at the time of publication.

Source: Quasi Quantitative Easing by the Fed?