In this comment I hope to shed some light on the purchases of treasury securities by the Federal Reserve in an attempt to explain possible ways to profit from the end of the so called "QE2."
To review, the Fed has purchased about $420 billion of Treasury securities since November 12. Through the end of June, the Fed estimated it would buy $850-$900 billion of Treasury securities, with $600 billion of those purchases related to the new purchase program [QE2] and the remainder coming from the reinvestment of maturing agency and MBS securities. Breaking it down even further, the Fed has purchased about $310 billion related to the $600 billion part of the program.
The chart below (click to enlarge) shows the expansion of the Fed's balance sheet. As you can see, the Fed's holdings have exploded over the past few years, which are mostly the purchases of agency, MBS, and Treasury securities.
An interesting observation regarding these purchases has been the increased concentration of specific issues targeted by the Fed. The graphs below (click to enlarge) display the numbers through mid March. This month, the on-the-run issues have been of particular interest to the Fed, with almost 50% of its purchases coming from these issues. Additionally, in March, almost two-thirds of its purchases have been of securities issued within the past 3-months.
So the question that comes to fruition is as follows: How does one play the end of the Fed purchases? I will present a few thoughts and ideas in the following paragraphs.
1. Short Treasuries. Using TBT (TBT) or PST (PST) one can benefit from the decline in Treasury prices (rise in yield) as the Fed tapers off purchases. Keep in mind these are double short ETFs. The case for this play can be explained by the improved economic data and the elimination of government purchases, which have been providing support for prices in my opinion. This spurs a new question, a possibly a new article: Has the debt monetizing awoken the sleeping giant (inflation) from the 1970s? Only time will tell but going short government securities may help to sooth some of the increase in the prices of products. Keep in mind, I don’t think that we will see inflation spiral out of control, but it doesn’t hurt to be informed. To offer ideal protection, purchasing TIPS would be a solid play (see below).
2. Do we see a correction in the equity markets? Will the above mentioned liquidity suddenly dry up and stop fueling the equity and commodities rallies? Since the Fed has been purchasing securities in November, the S&P500 is up 12% and the CRB Index is up about 20%. Granted, if we look back 2 years, both indices are up tremendously. Only time will tell if the Fed's pullback of purchases will negatively affect the equity markets.
3. What I found interesting about the graph below (click to enlarge) is the simultaneous rise in yield of the 10-year Treasury note and the amount of Treasury securities the Fed holds on its balance sheet. In fact, the yield actually moved lower when the Fed was quiet, in contrary to logical reasoning that the increased purchases would drive prices higher and yields lower. Now granted some of the yield decline in 2010 occurred in anticipation of the current Treasury purchase program and disappointing economic data. But one cannot deny the relationship is a quite remarkable. Now lets assume the rise in prices begins to take a larger than expected toll on consumers and GDP slips. Do investors become more risk adverse, in turn pushing yields lower? Again, only time will tell.
4. Personally, I think playing TIPS is the right idea. They will offer security in what is likely to be an inflationary environment down the road, especially if growth really begins to pick up. I'm also not a huge risk taker, so if a 2% return on a TIPS issue helps me sleep at night, so be it.
As I stated earlier, I think it's important to be aware of what the future implications will be, given the current conditions presented to us. Staying ahead of the game is one way not to lose a sizeable position.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in IPE over the next 72 hours.