I have talked quite a bit lately about how investors' hunger for more stimulus has created a perverse marketplace where bad news is good in terms of economic indicators. The key point is that when the market wishes for bad economic data, it is
"...putting the cart before the horse. The market shouldn't hope for bad economic news because such news would prompt the Fed to act when the whole reason for the Fed's action in the first place was to improve economic conditions."
With the announcement of an open-ended asset purchase program wherein additional purchases beyond year-end will be contingent upon - to use the Fed's own words - "the outlook for the labor market", the Fed has implicitly encouraged this behavior. Indeed, after December (the central bank will be buying until then regardless) there will be an explicit, quantifiable link between bad economic data and more asset purchases: bad data equals $40 billion or more in new stimulus. As David Rosenberg of Gluskin Sheff & Associates puts it,
"The payroll data always move the market but now more than ever and the Fed's explicit goal of generating "substantial" improvement in the jobs market will ensure that this 'bad news is good news' psychology will remain fully intact."
If you think about what this psychology encourages it is truly disturbing. The market is already grossly disconnected from global economic fundamentals and rising solely on P/E multiple expansion as consensus EPS estimates continue to fall. The Fed's actions have ensured that the market will continue to rise with bad data resulting in equity prices that are ever farther removed from underlying fundamentals. In short, we are building a bigger and bigger castle on a foundation made of quick sand.
Right next door to the equities castle, the Fed is constructing two more giant chateaus and these too are built on shaky foundations. The Fed is monopolizing mortgage backed securities and Treasury bonds, a move that will invariably destabilize the underlying market for those assets. In a previous article, I discussed how much of the monthly supply of MBS the Fed will likely be in the market for once QE3 kicks into full gear. Now, courtesy of a Bank of America note to clients, we have a more complete picture of what the market for Treasury bonds and MBS will look like over the next two years.
According to Bank of America, the Fed will end up purchasing around 60% of the monthly supply of MBS, and if its current pattern of buying persists, it may end up purchasing 90% of 30-year conventional issuance. By the end of 2014, Bank of America sees the Fed owning 33% of the entire market.
For Treasury bonds, the prognosis is even more shocking. Bank of America, like many other commentators, expects the Fed to announce unsterilized purchases of Treasury bonds once it runs out of short-end bonds to sell in December. Extrapolating from that assumption, the bank estimates that by the end of 2014, the Fed will own 65% of Treasury bonds with maturities of between 6 and 30 years. Notably, Bank of America says that,
"...the Fed will begin to run out of issues in the 8y-10y bucket and will be forced to buy newly issued 10y notes should they choose to maintain the same distribution" (emphasis mine)
That would mean direct financing of the deficit by the central bank.
There are two key takeaways here. First, Bank of America estimates the Fed's balance sheet will be $5 trillion by the end of 2014 which, by some estimates which factor in the current trajectory of prices with the increase of the Fed's holdings, equates to $190 oil and $3,350 gold (SPDR Gold Trust ETF: GLD). While these estimates are admittedly rather speculative, what is not speculative is the notable underperformance of the dollar index compared to the CRB commodity index over the last few weeks. In other words, whether you believe in $200 oil or record high gold prices or not, what you can bet on is a decline in the dollar relative to commodities.
The second key takeaway - and I think this is more important - is the prospect that the Fed will own 65% of Treasury bonds with maturities between 6 and 30 years. When rates start to rise and the prices on those bonds begin to fall this giant market which for several years now has been manipulated by the Fed, is going to unwind. As David Stockman notes,
"Trillions of treasury paper is funded on repo: You buy $100 million in Treasuries and immediately put them up as collateral for overnight borrowings of $98M. Traders can capture the spread as long as the price of the bond is stable or rising, as it has been for the last year or two. If the bond drops 2%, the spread has been wiped out. If that happens, the massive repo structures - that is, debt owned by still more debt - will start to unwind and create a panic in the Treasury market. People will realize the emperor is naked."
This will be the trade that makes careers: short U.S. Treasury bonds (iShares Barclays 20+ Year Treasury Bond ETF: TLT). The emperor is indeed naked and eventually, the castles he has built will collapse.