Fed Purchasing 20% Of New Issuance

Includes: EDV, TLT, VGLT, ZROZ
by: David Cretcher

First the Fed hinted, and then they head-faked and now they acted, announcing yesterday they will taper their bond buying. The Fed will reduce buying by 5 billion dollars per month of both treasuries and mortgages. This is a decrease of 13 percent. They will now buy 75 billion per month instead of 85 billion.

After responding in near panic at the hint of this action earlier this year, the stock markets responded enthusiastically at the news. The Dow increased 292.71. The bond market simply yawned. The Fed's actions will give the press plenty to discuss on what this will mean for investors, citizens, business, and the economy.

An analysis shows, the effect of the Fed's decision will have little or no effect on the bond market and the dynamics of interest rates. The Fed is not reducing its balance sheet, it is instead expanding it at a slower rate. They are letting off the accelerator, not putting on the brakes.

A Shortage of Bonds

The effect for investors is a ten billion dollar per month increase in the available supply of US Bonds. If the Fed doesn't buy the bonds, then someone else must. When investors buy bonds, they must give up buying something else, like a stock, or real estate.

In the short term, the supply of stocks and bonds is relatively fixed. If investors now buy 10 billion more in government bonds, then they must also buy less of something else. In short, QE causes a bond shortage.

Before easing operations began, the Fed held 800 billion in US bonds. As of October 30, 2013 the Fed has 3.571 trillion on its balance sheet. The Fed has removed 3.5 trillion of bonds from the private markets. This is a 38.5 percent increase from a year earlier.

As shown in Exhibit 1, at the old rate of 85 billion per month the total holdings at the Fed would increase to 4.591 trillion, ignoring run-off from maturing bonds. This is a 27.1 percent yearly increase. At the new 75 billion per month rate, the number next year will be 4.471 trillion, a 24.2 percent increase. A net difference of three percent. This is why the bond market yawned. It's just not much change.

Exhibit 1: Total Fed-Owned Bonds

Monthly Fed -Owned Increase
Purchases Bonds
Q3 2012 0.85 2.5
Q3 2013 0.85 3.6 44.0%
Q3 2014 proj. 0.75 4.5 25.0%
Q3 2014 unchg. 0.85 4.6 27.8%

The Fed bought 21.3 percent of the monthly issue in 2012, and 23 percent in 2013. It is projected to purchase 19.7 percent in 2014.

Exhibit 2: Monthly Bond Purchases as Percent of Issuance

In trillions Monthly Monthly % Fed
Purchases Bonds Purchased
2012-10-01 0.85 4 21.3%
2013-10-01 0.85 3.7 23.0%
2014 proj. 0.75 3.8 19.7%

Shown in Exhibit 3, the total amount of outstanding treasury and mortgage debt is 20.1 trillion, of which the Fed owns 3.6 trillion or 17.9 percent. At the new rate of 75 trillion, they will own 4.5 trillion next year, around 21.7 percent depending on the actual issuance.

Exhibit 3: Fed-Owned Bonds as a Percent of Outstanding

In trillions Total Bonds Fed -Owned % Fed-owned
Outstanding Bonds
Q3 2012 19.6 2.5 12.8%
Q3 2013 20.1 3.6 17.9%
Q3 2014proj. 20.7 4.5 21.7%

Private-Sector Bond Supply is Flat

The net result, shown in Exhibit 4, is 19.6 trillion in outstanding treasuries and mortgages in Q3 2012. Net out the 2.5 trillion owned by the Fed and the public sector supply was 17.1 trillion.

This year there is 20.1 trillion outstanding and the Fed owns 3.5 trillion, leaving 16.5 trillion available. This is a decrease in available bonds of 2.37 percent.

In 2014, the supply is projected to be 16.2 trillion in private-sector bonds, a further decrease.

For investors, the net effect of the Fed's policy is fewer bonds on the private market next year then this year. It is difficult for bond prices to increase, and therefore interest rates decrease, if there are few bonds on the market.

Exhibit 4: Private-Sector Bond Supply

In trillions Total Bonds Fed -Owned Private Sector
Outstanding Bonds Supply
Q3 2012 19.6 2.5 17.1
Q3 2013 20.1 3.6 16.5
Q3 2014 proj. 20.7 4.5 16.2

It's Supply and Demand

The bond market, like most markets, is governed by supply and demand. If the economy is growing and the bond supply is flat, the price of bonds will have upward pressures and the interest rate will face downward pressures. Low interest rates is the Fed's intention, and it is still the Fed's goal. Mild tapering is not going to change that.

The Fed policy announcement is more of a public relation announcement than a major policy shift. The Federal Reserve is reassuring the public that it can quit buying bonds if it feels like it. Yesterday, it felt like it.

When the Fed first hinted at tapering the markets reacted with 138 point jump in the 10 year Treasury rate. The numbers behind the Fed change do not warrant such a large increase in interest rates. Even if the Fed increases the amount of taper, the total numbers will not change significantly.

Investment Strategy

The overall effect of the Fed's decision is too small to significantly affect the bond market and the level of interest rates.

The over-reaction of the market to the news, makes Treasuries a short-term buying opportunity. Investors willing to speculate can participate by purchasing ETFs like TLT and VGLT. Aggressive investors can use zero coupon Treasuries (EDV, ZROZ).

Conservative long-term bond buyers can continue to confidently buy high-coupon premium "cushion bonds". If the market is flat, they earn the high-coupon, if interest rates decrease they get a capital gain, and if this analysis is wrong and rates rise, investors are cushioned by cash flow from the high-coupon and the lower price sensitivity to higher interest rates. The curious can learn more here.

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.

Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.