The Fed Is Doing What Bernanke Is Saying

by: Diffusion

Two weeks ago I published an article showing that the Fed was preparing itself for the tapering. Now, as Mr. Bernanke backpedals, the Fed changes course, too.

The chart below shows what the Fed did in the six months prior to when the tapering bomb was dropped (left), two weeks after that (middle), and one month after that (right). Clearly the Fed was altering its behavior along the course.

Before "tapering" was mentioned, the Fed bought an equal amount of 5-year, 7-year, 10-year, and 30-year Treasuries through POMOs. But in the two weeks after that, the Fed bought more 5-year notes and fewer 30-year bonds. Bond investors should be familiar with it --- the Fed was shortening duration.

Shortening duration is a textbook strategy to mitigate risks of rising interesting rates. Since interest rates and bond prices move in opposite directions, rising interest rates means diminishing profit or even loss of a bond portfolio. Long-term interest rates are artificially held back by QE and will climb up if the Fed tapers. The Fed was shortening duration in anticipation of the tapering.

But the Fed is a government agency. It may not care about loss or profit of its Treasury portfolio. Even though, it's still better to hold short-term Treasuries.

Unlike other institutions that issue an IOU to raise cash, the Fed issues IOM --- I owe myself. Let's say the Fed issues IOM and puts it in the right pocket. Simultaneously it creates cash and puts it in the left pocket. Then the Fed uses the cash to buy Treasuries from banks. Capital is injected into the financial market. When the Fed closes the position, by either selling the Treasuries back to banks or by receiving principal pay off when the Treasuries mature, it uses the received cash to cancel out the IOM in the right pocket. The cash comes from thin air and goes back to thin air.

For all the Treasuries the Fed holds on its balance sheet, there is an equal amount of cash circulating in the financial market. The excessive capital will flare inflation when the economy eventually recovers. Cleaning up excessive capital is a necessary step to lay a solid foundation for stable economic growth. It also helps in restoring investor confidence. The Fed better hold Treasuries that mature sooner so it can drain off the excessive capital quicker.

Things changed again. Mr. Bernanke sounds dovish lately. Likewise, the Fed stopped buying more 5-year notes through its POMOs. As shown in the right chart, the Fed bought the same amount of 5-year, 7-year, 10-year and 30-year last month, meaning in the last two-weeks, the Fed reversed course to buy a lot of 30-year bonds but few 5-year notes.

If the Fed were a person, it would be an honest one. The head says something and the body follows suit. As for now, what the Fed says and does both point to a dovish monetary policy. The Fed, as Mr. Bernanke claimed, is more transparent.

Nonetheless, being transparent also means the Fed is increasingly driven by economic data. When economic data fluctuate, the Fed may swing. Investors, be aware.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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