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If I had $2.3 trillion dollars, what would I do? That is the Fed's predicament. It has expanded its balance sheet $2.3 trillion dollars buying mortgage backed securities (MBS) and U.S. Treasuries. The last round of Quantitative Easing ends today.

Six-hundred billion was created and used to buy short term U.S. treasuries. The Fed has told us after the last two Federal Open Market Committee (FOMC) meetings that it was not going to reduce the balance sheet. The Fed is going to reinvest money from maturing securities into new issue treasury bonds.

During the last six months the Fed purchased 84% of all Treasury offerings. It concentrated the purchases in the shorter term (less than seven year) issues. Talking heads on TV bemoan the end of QE2. They tell us the market has to fly on its own; the Fed does not have any more money to keep interest rates down. The party is over. Well…not really. Here is why.

The popular perception that interest rates are going to spike because the Fed isn’t there to buy them may not hold up. First of all the Fed sold $19.5 billion in mortgage backed securities beginning in March. Even though the residential real estate market is depressed, people still move every month. When they sell their home, the mortgage is pre-paid to the owner of the MBS. This is called “runoff.”

According to National Mortgage News, the Federal Reserve purchased $1.25 trillion in MBS from December 2008, to June of 2010. By the end of 2010, runoff had reduced its holdings to one trillion dollars.

Is the Fed broke? The simple answer is no. Six months ago, $250 billion had been paid back from the MBS holdings in prepayments. It sold $19.5 billion in private-label MBS in March and April. The Fed receives interest payments on its holdings. If we calculate simple interest of one-percent (because most treasuries are short term), that equals $20 billion a year, or $1.67 billion per month.

Let’s extrapolate runoff on the Fed’s portfolio of 20% per year. This was the amount experienced as of the end of 2010. That would add another $100 billion in prepays in the first half of 2011.

We don’t know the exact mix of Treasuries the Fed purchased over last two years. We know QE2 concentrated on shorter term issues. Treasuries make up approximately one-trillion of its balance sheet. In a laddered portfolio, with an average maturity of two-and-a-half years, 20% ($200 billion) mature each year. If these maturities were evenly spread throughout the year, this would be $16.67 billion per month.

A little back of envelope math shows us the Fed has free cash of:

  • $250 billion ---runoff at end of 2010
  • $100 billion ---runoff in first six months of 2011
  • $ 19.5 billion-private label MBS sold in spring 2011
  • $ 20 billion ---interest received in 2010
  • $ 10 billion ---interest in first half of 2011
  • $399.5 billion total as of 6/30/11

Interest payments of $1.67 billion, $16.67 billion in prepayments on MBS and $16.67 in maturing Treasuries, grow the Fed’s cash position over $35 billion per month.

With a free cash position of $400 billion and cash flow of $35 billion per month, the Fed has plenty of ammunition to intervene in Treasury markets for some time. It will still be the largest buyer of Treasuries, until it says it is not.

Remember, Chairman Bernanke said a change in policy of reinvesting maturing Treasuries would take at least two meetings, and be announced in the FOMC press release.

These observations are not meant to encourage irrational exuberance. QE2 may gone, but it is not dead!

Source: QE2 May Be Gone but It's Not Dead