QE3 update: modest increase in bank reserves

US bank reserves at the Fed grew about $27bn, with the "other" category showing up in reserves this week (as Lee Adler discussed earlier). Overall the pace of reserves growth is still quite modest on a relative basis (currently reserves are at the level of early September.) Further increases are expected in December as more MBS purchases settle.

Bank reserves (source: FBR)

Moreover, the Fed's balance sheet unexpectedly shrunk by $20bn this week. Part of the decline has to do with MBS paydown from all the mortgage refinancing activity. Certainly there is some noise in the balance sheet measures and reserves on a week-to-week basis, but the Fed is definitely being cautious. We may see a more aggressive approach to bank reserve expansion after Operation Twist (see discussion) winds down - likely early next year. There is about $50bn of short-term notes left to sell (chart below).

$bn

A number of economists continue to argue that increasing bank reserves is not productive at this point in the cycle because it will not stimulate further credit expansion (while risking inflation).

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Three reasons for extremely low swap spreads

US swap spreads continue to decline, as the 5y spread hovers below 10bp. A rate swaps is basically a stream of floating (3m LIBOR) vs. fixed payments. The level at which fixed payments are set (the swap rate) is therefore the market's projection of future LIBOR. This decline in spread is the market's expectation that future LIBOR to treasury spreads will be lower. Three factors are contributing to this decline:

1. With the ECB backstop to the Eurozone sovereigns in place, the perceived risks to global banks have subsided. Improved health of the global financial system means lower cost of funding for banks, which should (loosely) translate into lower LIBOR to treasury (TED) spread in the future - thus lower swap spread.

2. As LIBOR converges to CD rates (see discussion), which have generally been lower, the market is pricing in lower overall LIBOR levels in the future (reducing swap spreads).

3. The Fed has been taking duration out of the market, first via Twist (see discussion on how Twist reduced duration) and now also with MBS purchases (see discussion). With mortgage refinancing accelerating, MBS durations decline. When fixed income investors hedge against rate risk, they usually want to pay fixed and receive floating on a rate swap. But as the need to hedge fixed income portfolios declines (because portfolios have lower durations) so does the demand to pay fixed - which reduces swap rates and spreads.

If anything, investors now want to receive fixed on rate swaps to synthetically increase their portfolio durations. An example of that may be a life insurance company that has long-term liabilities (death benefits) and needs long term assets to avoid a duration mismatch.

5y Swap Spread (source: FRB)

Note that the bump in swap spreads during the May-June period was all driven by the Eurozone, as LIBOR to treasuries spread widened and so did swap spreads. A change to any of the three factors above (like the May-June period) could reverse this trend. For now however the ECB, the Fed, and new LIBOR regulation should keep swaps spreads low.

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Draining duration from the markets

As part of Operation Twist, the Fed was taking tremendous amounts of duration out of the market. In effect the average duration of outstanding fixed income products in the market was lowered by their action. The idea was to create a shortage of high duration product, thus lowering long-term rates.

By converting bond purchases and sales into 10-year equivalents (duration adjusted) one can measure how much "effective" 10-year notes have been taken out of the system. With Twist continuing on and agency purchases commencing shortly, this process is going to accelerate. 

Source: JPMorgan

Some are asking - so what? Who cares if the market's overall duration is shortened? The answer is that ultimately it is the institutional investors such as corporate and state pensions who will get hurt the most by this process. These investors have long-term liabilities and will now be increasingly struggling with the so-called "duration mismatch". They also have a return hurdle. That allows corporations (even highly leveraged ones) to issue longer dated paper and force institutions to accept ridiculously low yields for the credit risk taken (see discussion). And pensions' portfolios stuffed with higher risk paper should be everyone's concern.

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"Moral hazard 101" with professor Draghi

The ECB has been quite clear about focusing their bond buying on the short end of the curve (see this discussion). There has been some speculation that Draghi will only buy short-term bills, but we got some clarification today. The ECB will target the short end of the curve of up to 3 years.

Bloomberg: - European Central Bank President Mario Draghi told lawmakers he’d be comfortable buying bonds with maturities of up to about three years, said Jean-Paul Gauzes, a member of the European Parliament.

Purchasing short-dated bonds doesn't constitute state financing, Draghi said during a closed-door parliamentary session in Brussels today, Gauzes told reporters afterwards. “He thinks it’s not a violation of the treaty and you can do it under the current legal framework,” Gauzes said. “He said for example three years is ok, 15 years no.”

Of course it's not "state financing" because that would be outside of ECB's mandate. Right.

The market is reflecting just such a policy with the Spanish sovereign curve staying quite steep at the short end. This policy is basically the reverse of what the Fed has been trying to do via Operation Twist.

Spain's sovereign curve - now and 2 months ago (Bloomberg)

When the bond buying program is in place, this "reverse Twist" will become easy pickings with low risk for hedge funds. Traders will buy bonds just outside the three year range and wait for them to roll down the curve. They are going to capture the relatively high income as well as the capital appreciation from the rapidly declining yield as the maturity shortens with time. And once the bonds are within the range, there is a "free put option" from the ECB who will not permit yields from rising above a certain levels.

We all know what happens when central banks provide a free put option (such as lowering rates every time the housing market sneezed during the boom years in the US - see this chart for example). Welcome to "moral hazard 101" with professor Draghi.

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Draghi engineers a "reverse Twist", again

By focusing on the short end of the Eurozone periphery curves, Draghi's comments resulted in curve steepening for both Italy and Spain. And as anyone at the Fed will tell you, this is exactly the opposite of the effect one needs to help these economies. The Fed's effort for almost a year now has focused on flattening the yield curve, while the ECB (both in July and today) has managed to accomplish the opposite.

1 day change in Spain's sovereign yield curve  (source: Bloomberg)

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Twist is Fed's most effective policy tool right now

The most probable outcome of the FOMC meeting currently under way is the continuation of "Operation Twist" and possibly the extension of the current “exceptionally low… through late 2014” rate guidance to "mid 2015."

Other policy changes are much less likely. A drop in the rate paid on bank reserves is possible but not preferable because it could destabilize money markets functioning (potentially pushing repo rates deep into negative territory with a sharp drop in liquidity). A UK style policy to lend to banks below market rates (to encourage lending) is also unlikely because of legal limitations and political ramifications of the Fed lending to banks again. And there is almost no chance that any sort of unsterilized asset purchases (QE3) will be announced.

The Fed should be quite happy with the impact of the Maturity Extension Program (Twist). The central bank has taken a considerable amount of duration out of the treasury market. This happened just as demand for treasuries rose due to escalating problems in the Eurozone as well as negative rates in the "safer" European nations. This combination has created the most accommodative long-term rate environment in recent US history. The 10-year zero coupon real yield is at record low of negative 82bp.

US 10y zero coupon real yield  (source: Bloomberg)

Many would argue that this extraordinarily accommodative policy is not feeding through to the economy. But there is very little the Fed could do about that other than possibly shifting to MBS "Twist" (which is a distinct possibility down the road). Increasing bank reserves via QE3 will NOT make conditions any more accommodative than they already are. That's why Twist, and later sterilized purchases (which may at some point involve nontraditional sterilization techniques such as issuing Federal Reserve bills), will continue to be the primary tool for easing.

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What to expect from the FOMC tomorrow

There has been some confusion about the potential policy actions the Fed could undertake at the next meeting. This is what we could expect from the FOMC tomorrow as well as the corresponding market reactions:

• It is highly likely the committee will announce an easing action of some sort.
• The policy decision will probably involve extended guidance, projecting fed funds rate to be near zero for longer than in previous guidance announcements. Once again, this is not a commitment, only guidance.
• The Fed will also likely announce some form of a securities purchase program. The purchases would take one of the three forms:

1. Extension of Operation Twist. This is the easiest form of policy change for the Fed to implement since the program is already in place. The problem is that the Fed has only some $175bn of short tenor securities to sell (in order to buy the same amount of longer tenor bonds), which would take it to September. That may be enough however as the FOMC agrees to revisit the situation then ("kick the can" policy).

       Market reaction: If this were the only policy move, risk assets would sell off.

2. Sterilized purchases. The Fed would use 1-4 week reverse repo to avoid increasing bank excess reserves (avoid "printing money") . An alternative or a complement to using reverse repo is for the Fed to accept term deposits which would also reduce reserves. The one criticism of this program is that it could put upward pressure on 1-4 week rates because the Fed would be constantly in the market borrowing short term money. But this is generally viewed as an acceptable risk.

As discussed before, this program is likely to involve MBS purchases for a couple of reasons. MBS yields have a bit more room for compression than treasuries do. Also focusing on "helping" the housing market would be politically more palatable for the Fed than being seen as funding the federal budget deficit.

      Market reaction: Depends on the size. $400-$600bn would be a positive for risk assets

3. Unsterilized (outright) securities purchases, otherwise known as Quantitative Easing (QE3). Securities purchases would be funded by increasing the bank excess reserves ("money printing"). As discussed before, this scenario is unlikely because it would be kept as a "weapon of last resort". It would be employed in an absolute crisis situation, such as a major sovereign default in the Eurozone or an Iran induced global oil disruption. QE is also highly unpopular and the Fed is not impervious to popular opinion. Given the current expansion of credit in the US, QE would be difficult to justify.

     Market reaction: Risk assets would rally (obviously depending on what else is going on globally)

All of these programs will have only a limited effect on the US economy. Even MBS purchases, the best option out there, are not expected to yield tremendous results in generating growth and jobs. A 30-year mortgage at 2% will put some cash in people's pockets for those who can refinance. But it's not going to improve the credit score for those who can not refinance or do not qualify for a mortgage. And the 10-year treasury at half its current yield (which is what Japan has) is hardly going to help improve economic activity. But the Fed promised to stay vigilant, and given the limited toolbox, these policy moves may be the best the central bank will be able to accomplish on its own.

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Fed running out of short-term notes

Here is a quick follow-up to an earlier post discussing the Fed's diminishing short-term treasury note position. The Fed is basically running out of the 2-3 year notes to sell in order to buy long-term treasuries as part of Operation Twist (officially known as Maturity Extension Program or MEP). BofA is projecting that by the time of the FOMC meeting this month, the Fed will have $175bn of short-term treasuries on its balance sheet. That's enough to extend Operation Twist only through September. Beyond that point the Fed is likely to embark on sterilized purchases (possibly MBS) in order to extend the easing program.

Source: BofA via Bianco Research

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Fed's operation twist is distorting the treasury market

Fed's Operation Twist is starting to introduce some "unintended consequences" into the market. The 10-year treasury yield has collapsed on the back of Eurozone's latest troubles. One would expect the two-year note to trade with a lower yield as well. But in fact the 2-year yield has been moving up. The Fed wanted to lower long-term rates without impacting shorter term rates -  and that is proving difficult.

2yr vs 10yr treasury yields

Even today, in the face of new fears about Spain (with a potential run on the banks there), the two-year treasury yield is still moving higher.

Today's treasury yield move by tenor

The question now is whether these yields will reverse direction once Operation Twist ends this summer. Given the global economic backdrop, the Fed will likely not want to end the program, but the central bank will soon run out of two-year treasuries to sell. The next step will be sterilized purchases.

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The Fed sold half its short-term notes via Operation Twist

The Fed has now sold over half of its short-term treasury note holdings (sold $269bn with $257bn remaining) as part of the Maturity Extension Program (Operation Twist). The bulk of the purchases have been in the 8-10yr and the 20-30yr buckets.

Source: Barclays Capital

Now what happens when the Fed runs out of short-term paper to sell? The program is supposed to end this summer, likely before the Fed actually runs out of short-term notes. It is possible the Fed will extend the program until it simply has no more notes to sell. Here are some possible alternatives after that point.

1. Let the program expire and/or wait until some of the paper in the 3-6yr bucket rolls into the shorter term bucket giving the Fed more "gunpowder".

2. Convert Operation Twist into sterilized asset purchases. That essentially accomplishes the same thing, except rather than swapping 2-year notes into long dated treasuries, the Fed would essentially be swapping short term (possibly overnight) repo loans into long-term treasuries.

3. Move to do more outright purchases (QE3). This outcome is unlikely even in the face of Friday's employment numbers for reasons described here.

Either way, at its current pace of Operation Twist the Fed will run out of short term notes about six months from now (roughly around the one-year anniversary of the program).

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Is the Fed informally targeting mortgage rates?

Guest post by TheDealer

There is no direct evidence for this, but folks on trading floors are saying the Fed may be trying to smack down 30-year fixed mortgage rate. The average rate is still near historical lows.

30 year fixed mortgage rate (source: BankRate.com)

But it seems every time the rate pops up from the lows, a series of Operation Twist trades takes place.  Here is what happened to the treasury curve Friday - some visible flattening action.

Friday's change in treasury yields by maturity

Call me crazy but I don't think this is a coincidence.

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Treasury yields likely to rise in 2012

This week we finally saw a sell-off in longer term treasuries after a relentless rally. With a great deal of new supply hitting the market, US treasuries will be under further pressure going forward.  Here are six reasons that make higher yields more likely in 2012:

1. In 2010 the onset of QE2 pushed treasury yields lower (within a month of the Jackson Hole announcement the 5yr yield was lower by 16bp).  As discussed earlier however, the probability of a quantitative easing redux has declined markedly.

2. Operation Twist which has been providing support to longer term treasuries is expected to end this summer.

3. Many managers who were short or under-invested in treasuries (such as PIMCO) have capitulated, as treasuries continued a powerful rally in 2011. Investors have been trying to short US treasuries for some time with the view that QE programs will ultimately debase the dollar and accelerate inflation. These projections did not materialize and the capitulation trade caused treasuries to rally further. The chart below shows shares outstanding of the ProShares Treasuries 20+ Year UltraShort ETF (ticker: TBT). It allows investors to easily short longer dated treasuries on a leveraged basis. The capitulation trade is clearly visible in the decline of the number of shares outstanding.

TBT shares outstanding (Bloomberg)

The Long Bond became known in some trading circles as the "widow maker" because of the losses numerous traders endured trying to short it. Many have since said "no more!"  Now with fewer shorts in the market, there will be less support for treasury prices going forward.

4. Treasury yields have decoupled from "risk assets" such as equities. This is unlikely to be sustainable going forward.

5. Between the Fed's Liquidity Swap and the numerous actions by the ECB, the funding pressures in the eurozone have receded materially. Yet treasuries have not adjusted accordingly. The chart below compares 10-year treasury yield with the 3-month EUR/USD basis swap rate.

10-year treasury yield vs. EUR/USD 3m basis swap spread (Bloomberg)

6. Even though foreign private investors continue their love affair with treasuries, it seems that foreign central banks may be losing their appetite for US government debt. Treasuries holdings at the Fed by foreign central banks are showing declines.

Foreign banks' holdings of US treasuries at the Fed  (Bloomberg)  

There is no shortage of new supply, as the US Treasury is expected to hit the market with net new issuance of about $81bn/month excluding what the Fed is expected to purchase (see Businessweek - forecast by Credit Suisse). Clearly an unexpected shock in Europe could trigger a new rally in this market, but absent such an extreme event, longer term treasury yields should rise in 2012.

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Operation Twist update

Part of the explanation for the strength in the longer term treasury markets continues to be Fed's Operation Twiest

Businessweek: “The Fed purchases were constructive for the market, especially in a low-volume environment,” said Ian Lyngen, a government-bond strategist at CRT Capital Group LLC in Stamford, Connecticut.

The chart below shows net purchases and sales (market values) of treasuries by the Federal Reserve since October 3d.  They've been targeting the 7-year, the 10-year, and the 30-year treasuries (including TIPS) against the 2 and 3-year notes.  Some of their rationale for the program was to bring down mortgage rates, a goal that was accomplished in part by the eurozone crisis that strengthened the dollar and created demand for treasuries.

Operation Twist: Fed's purchases and sales (market value, not notional) of treasuries by maturity ($ billion) - including TIPS

Operation Twist is expected to end in June of this year.  To the extent we have any sort of stabilization in Europe, some of the flattening of the yield curve we've seen in the last six months will be reversed in anticipation of the program's end.

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The Signature of the Twist

Below is a chart that shows how the Fed's Operation Twist is targeting treasuries of various tenors. Basically it's selling the 2-3 year tenor and buying the 7-10 year, with a bit of longer maturities sprinkled in.

Bloomberg

The impact of Twist on the market was clearly visible today. Typically on a day like today with equities down 1.7%, the two-year treasury would be bid up, but today it actually sold off.

1-Day Move in Treasury Yields (Bloomberg)

Going forward this may become a more common occurrence as the Fed tries to engineer a curve flattening. What remains to be seen is whether this will have any impact on the economy, particularly as credit spreads continue to stay elevated.

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