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One Step Closer

The Fed performed as was generally expected today. After James Bullard’s article came out in a pre-print last week, it was fairly clear the Committee was planning to edge towards QEII. By announcing that the Open Markets Desk would roll over received MBS and Treasury cash flows into the purchase of new Treasuries only, they are moving one step closer to explicit monetization of the debt. It was a necessary step – before they grow the balance sheet, they must stop shrinking it – and the logical first increment.

Buying Treasuries is qualitatively different from buying MBS. By buying MBS, the Fed is assuming from the prior owner of the MBS the risk of non-payment, and providing cash to the seller. The purchase removes to the government the credit risk, and has the same effect on the economy as if the homeowner paid off the mortgage with a pile of money he found in the mailbox one morning. It adds liquidity, but mainly it supports mortgage prices. Buying $100bln of Treasuries, on the other hand, is functionally equivalent to printing $100bln in cash and sending it to the U.S. Treasury to spend. The only difference is the order of transactions; instead of being (1. print money 2. buy services with cash) it is (1. issue bonds for cash 2. buy services 3. replace bonds with cash in the accounts of the bondholders). It is as if those bonds had never been issued – it is as if, in other words, the services rendered to the government in exchange for those bonds was paid for instead by currency hot off the presses.

Not surprisingly, bonds rallied on the news. The bond market has been steadily marching higher (10y yield down to 2.76% now), partly on the belief that something like this was inevitable. Bond buyers are going to increasingly feel bulletproof until one day they are not.

Equity investors always feel bulletproof, so the as-expected release sent stocks leaping as I figured they would. To be sure, indices had sold off in the morning so the afternoon jump still left the S&P -0.6% on the day. Stocks should not be going up on this. The economy is weak, and that is bad for earnings. The Fed is trying to inflate, and that’s bad for multiples. There is a widespread-enough myth that inflation is good for stocks that I expected a rally on “QEII news,” and there will be some knee-jerk buying because interest rates are falling, but in this case they are falling because of a large buyer stepping forward to make purchases for non-economic reasons. I am not sure what the catalyst will be for the next leg down, but it is getting overdue. If stocks can’t get up and over the June peaks in fairly short order, and on something better than the anemic volumes we have been seeing, then gravity will begin to take hold I think.

I was a bit surprised that the Fed did not remove the “extended period” language from the statement. Perhaps that was left for step two in September so that step three, outright balance sheet expansion, can happen in November as I expected.

The Fed initially didn’t say what Treasuries they will be buying, other than to say “long-term” Treasury securities, although the NY Fed later added more color (see below). I have said it before and I will say it again: if the Fed wants to drive up inflation expectations, it should buy TIPS and force the breakeven inflation rates wider. By buying Treasuries, they have been and will be forcing breakevens lower, which all else being equal will cause investors to think the market is pricing in less inflation. In this case, they’ll be buying TIPS but not enough, I’ll wager.

Oh yes, on inflation the Fed had this to say:

Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

I guess we’ll see, won’t we? The monetary policy makers at the Fed, ironically, are all Keynesians now. Sure, if M2 continues to grow at a 2% pace, then we’ll get neither growth nor inflation, but it will have nothing to do with resource slack. The Committee clearly wants money supply to start growing more briskly, however, and if they pursue QE with enough enthusiasm, they’ll get inflation no matter what the resource slack.

Late in the day, The ABC Consumer Confidence number jumped to -47. I only mention that because the decline last week to -50 was cause for remark as the second-lowest figure on record, so to be fair I should report the improvement.

Tomorrow, the monthly trade balance numbers and monthly budget statement are the only data on tap. However, the New York Fed will publish at 3:00 a schedule of dates, security types (nominal or TIPS), and maturity date range for their purchases over the next month. The Desk says that it will be concentrate on 2y to 10y maturities (not exactly “long-term” if they’re buying 2-year notes) but will be buying across the whole curve.

Oh yes, that is an interesting point as well. The 10y-30y spread today widened about 6bps. This is not the first time the 10y-30y spread has widened. As the chart below (Source: Bloomberg) shows, the 10y-30y spread has been going ballistic for a month and a half. 10s have also been getting richer relative to the 5y lately, although that is partly a function of the compression of the yield spectrum (5y notes are at 1.45%, so at some point they will rally slower even though the curve usually steepens in a rally).

Someone had nice timing, buying what were already all-time wides.

I am not saying that someone knew this was going to happen with the Treasury buying 10y notes and not buying as many 30y notes. Perhaps it was great analysis. But if no one smells the hand of a certain Wall Street institution that has previously been involved in trading inside information regarding Treasury issuance patterns…

Categories: Uncategorized
  1. Andy
    August 11, 2010 at 11:24 am

    Mike, I’m curoius as to your view of the following article in the WSJ today

  2. August 11, 2010 at 12:18 pm

    Personally, I think RAISING short-term rates is pretty stupid, but if you do it while printing lots of money then it probably doesn’t matter. You hear this every time we have an easing cycle: folks say “but the low rates hurt the little guy’s savings.” Sure, it pushes him willy-nilly into equities, which is bad, but the difference in money fund or CD returns between 1% (which is where they are if rates are around 2-2.5%) and 0% (which is where they are now) is pretty negligible.

    The author of that piece is trying to make an argument similar to Bullard’s, that low rates are part of the problem, but it’s a lot less sophisticated than Bullard’s. All of this, though, goes back to the totem of low interest rates. Low interest rates will not save the economy (well, in the long run it recapitalizes the banks, but there’s a lot to recapitalize). But that doesn’t mean we are doomed – the Fed can print money sufficient to cause inflation, thereby forcing real interest rates to be very low (at the short end, anyway). At 0%, short rates are neither problem nor solution. They are simply irrelevant.

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