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.