But there was no change in policy.
The Fed put out a balanced view… essentially that there is growth but that the pace of recovery “has slowed in recent months,” citing high unemployment, sluggish home values and investment in “nonresidential structures”. It even pulled out the deflation bogeyman by complaining that bank lending continues to contract. Despite all this, however, it still anticipates the economy to recover –at a more modest clip than formerly expected. And of course, there is no threat from inflation.
It gave the bears a little, and the bulls a little. It didn’t give the bulls quite what they wanted – more money – but it did commit to reinvest the proceeds of maturing agency debt and mortgage backed securities, which should surprise no one. It said that it would aim at keeping its holdings of securities around their current level, but that it will reinvest principal payments (including early repayments) on maturing non-Treasury securities into more “longer-term” Treasury securities.
The T-bond markets broke higher on the announcement. Indeed, they have been advancing for several months, at times seemingly inexplicably in the face of recovering stock and commodity prices and a falling US dollar. The Canadians have been loading up on Treasuries more than average this year, as you can tell in the chart below. Obviously, the news has been expected.
The trouble is, however, that the Fed has already been buying a lot more long term Treasuries than usual, and more to the point, there aren’t very many agency and mortgage backed securities on its balance sheet maturing over the next five years. Let’s deal with the former issue first.
As you can see, the Fed’s holdings are already more concentrated at the longer dated end than historically when more than 50 percent of the securities it purchased had maturities of less than one year. Today, the proportion of these securities that mature in under one year is 14%, if we exclude the mortgage-backed securities. Including the latter the Fed’s holdings of securities that mature in one year or less today is less than 5%… one tenth of the amount historically purchased.
Nevertheless, the Fed’s plan is to reinvest maturing agency and mortgage backed securities into long dated Treasuries. It may be too early to grasp all the implications of this controversial policy, but one thing we can conclude is that the news is not as bullish for Treasuries as it may seem.
Not only is the Fed already concentrated at the long end, but also, the market may be overestimating the amount of purchasing power that will support the T-bond in the short term.
Source: Federal Reserve (release h.4.1, table: 2)
Note that including mortgage-backed securities more than two thirds of the Fed’s securities portfolio is concentrated in securities with maturities of more than 5 years.
The total amount of Agency debt securities on the Fed’s balance sheet that mature in the next five years is around $130 billion. The total amount of mortgage-backed securities that mature in the next five years is $30 billion (nearly all $1.2 trillion of its mortgage backed securities mature AFTER 10 years). That amounts to $160 billion in total purchasing power over the next 5 years.
So we’re talking about $32 billion per year in purchases of long term bonds, which is about the same amount by which the Fed used to expand reserves balances each year prior to 2008 (by buying short term T-bills). Big deal. But, let’s say that some of those mortgages are paid back early. What proportion? No one knows for sure. We have heard estimates that the Fed could reinvest as much as $200 billion in Treasuries each year. Yet we can’t find that much maturing on its balance sheet in the next five years, in TOTAL. That means that in this bullish estimation, the market is expecting early repayments of as much as $800 billion over the next five years.
That’s most of the mortgages! Hard to swallow in our opinion.
We can’t imagine that the Fed will buy more than $50 billion of new Treasuries per year, unless it plans to expand its balance sheet, which is just enough to help the Canadians off their paper.
Has the outlook become so dire that the Fed has to rely on making meaningless announcements to reassure the markets?
We would stop short of recommending a short against the Treasuries because it is difficult to pick a top in any market let alone the Treasury market. However, this is a good argument for a short. For the brave hearts out there the ProShares UltraShort Lehman 20yr+ ETF lists in the NYSE under the symbol TBT. The ETF shorts Treasuries with long-term maturities and uses leverage to amplify the fluctuations in NAV.
It is currently trading at the lows of 2008, following the stock market crash, which may be an extreme, and reflects too much optimism about the reinvestment program.
Sincerely,
Ed Bugos
Chief Analyst
The Dollar Vigilante?
