Japan Vs US on Quant Easing

30 Year Capitulation

This looks like it to me. The Fed will not let the destruction continue much more. Mortgage stimulus is under assault. It will be a difficult month to be long via leverage, so it might be wise to stay small until right before June 24th, assuming the Fed does not step in to increase the buyback in some sort of surprise manner. Might be wise to hedge the purchase with gold bars, however. Mark the call at June 116'090. For entry, I suggest a 5% stop or better yet calls for August that will last well into the meeting.

Is This the Real Thing? (On Pending Reflation)

For the past several years, I have monitored treasuries against the dollar to confirm whether bearish dollar moves were sustainable. The treasury market foretold the lack of sustainability of the 2008 commodity boom; And it foretold the same impermanence when the Canadian dollar flew past parity. I have found no more fascinating and useful an economic indicator than the price of the 30 year treasury bond against the US dollar.

For the first time in recent years, universal dollar weakness, including weakness versus the Yen, is being confirmed by a little mini-flight on long maturity treasuries. This is worrisome as it obviously does not bode well for treasury bulls, and ultimately the Fed is placed into a little tighter corner than it has had to deal with recently. Either it turns the on faucet to increase the rate of debt monetization (as latest minutes reveal) via outright treasury purchases, accelerating dollar overshoot, or it shows restraint, letting the free market decide where the long term yield shall be. My flip flop between being a treasury bull and assumption of the more consensus reflationary scenario has come full circle.

The little bit of irony is that more the Fed targets longer rates, the more control it forgoes of future monetary tightening with disastrous consequences. This bodes poorly for the dollar, and serves as an effective devaluation by proxy. Investors may require a greater risk premium than before to buy treasury assets even in the face of a guaranteed treasury bid, as dollar exchange rates fall. This points to an environment where amidst Fed price supports and interest rate targeting, they end up being the only holder of long maturity treasuries. Upon commencement of monetary tightening policy, we will see sudden sharp moves on the long end. At that point, a mere removal of the Fed bid will see a several hundred basis point move on the long end. Central bank asset liquidation will be another story. For this reason, it will be a terribly politically difficult effort for the Fed to actually tighten this time around. It points to a replay of the Volcker scenario.

In the end, this (increasing QE) is unbelievably the right thing for the Fed to do if it is to successfully prevent liquidationists from taking assets from the current generation of capital holders. The dollar needs to be weaker to stimulate our export economy, end dollar hoarding and resume investment appetite. Inflation is a gift to the debt holders, and will stop bank insolvency in its tracks. The long run circumstances are an obvious one-off inflationary move the Fed is unable to neutralize unless it is willing to sell its agency MBS assets into an open market, once again shooting the mortgage market in the head. To me, this points to a permanent move to a higher price level.

The contrary argument of course is that no matter how much the Fed prints (within the under 10 trillion dollar range, of course) that it will be impotent against the wealth destruction we've already seen, itself in the many trillions. I find it easy to challenge that assumption, especially now that the Fed has so flexibly responded in its program creation. In this week's most important unnoticed headline, the Fed has finally activated the TALF, making the Fed's trillion dollar pledge actually useful to enable banks to offload old CMBS assets. PPIP is coming. And all of this several trillion dollars of treasury supply that is driving yields up will be spending into the economy that would not have otherwise happened so quickly. Government spending is directly augmented into GDP 1:1.

The multiplier effect of the impending monetary flood we are about to see in the next 6 months has a great chance of successfully offsetting the wealth destruction of the late crash of 08. Unlike the six hundred billion of monetary base currently sitting in excess reserves not being multiplied into the money supply, TALF, PPIP, QE, and treasury supply (stimulus) will be another story. That money will be multiplied, in a way Americans have never seen before.

S&P Breakout above 900?

Better prudence after a 35% rally from S&P 666 dictates we get a selloff at this price range, and consolidate for the rest of the year before the next move up.

But I have a hunch reality has nothing to do with measured moves and the sarcastic title of this message isn't far from one of the cards in the deck. Data is turning up, VIX is down, treasury yields are portending recovery (remember, even though rising yields are supply driven right now, that supply signifies a direct component of GDP increase), and even the most bearish natural gas is bouncing back up.

Just as the S&P fell from 1200 to the 900 range in a period of two weeks, there is no reason why the opposite could not happen in a frenzied short covering rally. There are no sizeable sellers here. Even though this move up may be 'fake', is it any less justified than the S&P falling from 1585 to 666 (58%) over what may be less than a 10% drop in GDP?

I am not loading up here, as I already did that on the way down. But I'm not selling in my long term account either. My less 'absurd' expectation is that the S&P corrects soon, and we go nowhere for a while. But on the same coin, as I've written before, what makes a multiple? Risk free yields are still 3-4% (25-33 multiple) on long maturity money, and investment grade yields are in the 4.7% (21 multiple) range on 10 year money. Considering an equities market trading so close to replacement value, a high multiple can be logically justified. There is enormous earnings capacity to be realized as the reflation continues. So how about a 21 multiple to a forward earnings stream of $90 (2-3 years out)? Just kidding. Or am I? Pricing on earnings expectations gets several years ahead of itself all the time, especially when people feel safe to buy. Regardless of how insane that may appear, arguing the S&P should be at 1200 versus 800 (or even 400) reveals itself as an equally valid subjective exercise. Flip a coin, but the in the long run, as long as the Fed is able to print, the odds are in your favor as a buyer considering how close we are to book value in so many stocks.

Quant Easing and the Real Fed Gameplan

I as well as many other Fed watchers was taken aback by the lack of aggressiveness on the Fed's meeting on 4/29, not only because I was long some 30 year treasury calls, but because the present deluge of treasury supply may not be met at these rate levels without more aggressive treasury buying. I am now no longer sure the Fed is planning on targeting money supply expansion going forward primarily via treasury purchases. This may be a tell to their long term game plan.

Right now, in the most simplified manner, the Fed is pursuing a dual-pronged attack of quantitative easing. The first being through Agency MBS purchases - $1250B committed, $450B likely used up so far; the second being outright treasury buying.

Here we see the effects of reactionary policy. The crisis related rotational movement of foreign central bank reserves from agencies to treasuries of similar maturity is obvious. The December short squeeze on the thirty year bond was likely mostly due to this.

Right now, the spread between the 30 year treasury and the 30 year mortgage rate is at all time lows, 40 basis points as I write this (4.05 vs 4.45 on the mortgage). Regardless of the recent 10-30 year US treasury weakness, mortgage yields are hanging low. This is entirely the handiwork of the Fed's appointed managers of the MBS purchase program, a direct result of targeted quantitative easing.

The Bottom Line: Is the Fed telegraphing their exit strategy?

In the face of a contentious treasury market threatening to drive rates far past the 3% 10 year line, and lack of aggressive treasury QE movement at the April 29th Fed meeting then today's open market operation where only 3B of 10+ year maturity treasuries were purchased, it isn't clear that the Fed is ready to commit to expanding money supply more than previously laid out. This could be for a myriad of reasons: desire to maintain Fed autonomy from congressional tinkering, or merely saving ammunition for what nastiness may remain in this recession.

It seems counterintuitive for the Fed to wait until rates go much higher to start buying treasuries again, as one might suppose they might get more low yield for their money if they buy while the market is already up at these levels. Waiting until 5% on the 30 year will likely make buying treasuries back to 4% more expensive than if they had just announced and supported a 3-4% target, teaching the market to do the brunt of maintaining the higher price on bonds.

Something else entirely might be going on. As we've seen, during this crisis the Fed has been very supportive of creating alternative measures to support credit. Fed funds are at record spreads to real borrowing costs for corporations. Banks benefit. Mortgage rates are touching record lows daily. Home borrowers as well as banks benefit (from refinancing streams making mortgages whole, and associated lower default rates). But what is missing is every other borrower is left out. Corporations' funding costs are directly tied to the treasury market, not the agency mortgageback security market. This benefits banks, while minimizing any stimulative effect all of this new monetary policy has. Borrow short, lend long - only banks are accommodated here.

This timid treasury buying, especially in the face of several trillion dollars of bailout-funding supply (the workings of fiscal policy), looks like an effort to intentionally not delay the refunding of bank balance sheets. While we may need more, not less, money supply now, the Fed may be targeting the credit multiplier rather than base money. Treasury quantitative easing would benefit base money, but might inhibit recovery of the credit multiplier. On the flip side, mortgageback quantitative easing targets the root of all of our problems, lack of available cheap capital to bid up houses. In the end, higher housing prices translates to increased bank solvency (and thus higher credit multiplier).

Doing the bulk of quantitative easing through agency mortgageback security purchases does provide another additional benefit. If inflation is to ever get out of control, despite consensus view that treasuries are much more liquid than agency MBS and easier to unwind in a tightening enviroment, there is a flip side benefit to liquidating a trillion dollar MBS portfolio in a contractionary policy environment: the Fed can do this without blowing up corporate funding costs. The future tightening will only shoot the housing market, a hopefully more resilient one. It might not be the worst bet to make that in a more highly regulated and less bubble like housing environment several years from now (where there is no subprime or option-ARM shoe to drop), sending mortgage yields to 8-10% (via liquidation of the Fed's MBS assets) might be something the housing market will eventually be able to endure without catastrophic consequence. With all of this going on, the nonresidential housing part of the real economy will not have to take a hit in its credit costs. Or at least, not as bad of one. This exit plan mutes the intensity of our post-recovery recessionary cycle.

What about the crowding out effect? If the US treasury is to sell several trillion dollars of treasuries in the next few years to fund its economic recovery without substantially increasing the money supply, there might not be much money left for corporate investment. The private sector, the most productive part of our economy, may lag and inhibit the strength of the ensuing recovery. On the other hand, this postulation is not quantitative. As discussed above, a longer run increase in the banking credit multiplier component of money supply in combination with the 1.25T of new money from the MBS quantitative easing may be more than enough to override the crowding out problem.

Conclusion: The Fed may not defend any interest rate level in the treasury market, might just be saving ammunition for later in the crisis, or this is more about playing politics and maintaining Fed sovereignty than what is actually best for the world economy. It isn't clear, but achieving bank system recapitalization in the most subversive manner possible is a difficult thing to do without bring about unintended consequences.

In this case, we may see a more dramatically bifurcated interest rate environment: mortgages rates lower than treasuries of equal maturity, with clear winners and losers as laid out above. In the long run, a larger bank credit multiplier (derived from a more profitable yield curve from high treasury yields) is where the Fed will get its best bang for the buck. Paradoxically, higher treasury yields resulting from lack of sufficient treasury-based QE (thus higher corporate funding costs) may actually inhibit bank lending, as a less stimulated economy might yield fewer credit worthy corporate (and thus private) borrowers. If the Fed continues to lag in long term treasury purchases several months out, that may be confirmation that these ideas are the actual plan.

Bond Trader Forum

I've been looking everywhere, and can not find anything. So I figured why not do it myself. In the next week or so, I will create a website bondtraderforum.com that is a central place for fixed income traders of all sorts to discuss the market, as well as chat about it.

Please send suggestions to features you might be interested in. I hope this to be a lean and exciting place to participate for everyone involved. A central meeting grounds of sorts.

EDIT: The basic site is up and ready to go. Features will be slowly added over the coming weeks. Please sign up!

Line in the sand (30 year bond)

After watching volatility come off aggressively this past two weeks, and seeing definite selling pressure here around 127'100, I am wondering if the short volatility trade may be keeping this pinned. Futures options expiration is next week, so aggressive buying (with the help of the Fed) with continued bond friendly data (especially if the stock market rally loses its steam) could possibly unhinge this as volatility sellers are forced to hedge their deltas.