Saturday, May 9, 2009

Fed Open Market Operations Update

Back on January 28th, we predicted that the Fed would soon begin purchasing long dated treasury bonds. You can view the article here.

Sure enough, on March 18th, the Fed announced that it would be buying $300 billion of long dated treasury bonds over the following six months. The first purchases were made on March 25th and have continued ever since. Here is a chart showing these purchases (click on images for larger views):

Since the initial euphoria of the announcement wore off, long dated treasuries have taken a thrashing. Here is a chart of TLT, the 20+ year treasury bond ETF:

The chart for IEF, the 7-10 year treasury bond ETF is not much better:

So far, the results have to be disappointing to the Fed. The Fed now has two choices. Their first choice is to stick with their $300 billion in purchases over the next six months and accept that long dated treasury bond yields are likely to continue rising. The second choice is to increase their purchases in the hope they will meet their goal of suppressing rates.

In our view, the Fed is likely to go the second route and announce an increase in treasury purchases in the coming weeks. The Fed has gone to great lengths to engineer this recovery and the risk of having interest rise in the face of a minor recovery is too great. A quick rise in rates will likely strangle the recovery before it has a real chance to take hold which would be quite an embarassment to the Fed, the Treasury and the President's entire administration.

Some have argued that Ben Bernanke is bound to realize that the treasury markets are just too big to control in any reasonable sense. For those people I would again like to point to my article written on January 28th which shows that Bernanke is certain of his ability to control the prices of long dated treasuries. Whether you agree with Mr. Bernanke's approach to the financial crisis or not, one thing everyone can agree with is that he is not gun shy about putting his theories into practice.

Moving on, the Fed first began to purchase agency debt (obligations from housing government sponsored enterprises) in September, stopped in October and November, began again in December and has continued ever since. Here is a chart showing these purchases:

The Fed has also been purchasing Agency mortgage backed securities since the beginning of the year. Here is a chart showing these purchases:

In total, the Fed has purchased $92 billion in treasury bonds, $85 billion in agency debt and $429 billion in agency MBS since last fall:

As you can see, Fed purchases of treasuries and agencies make up less than half the value of agency mortgage backed securities. In our view, this leaves a lot of room for the purchase of additional treasuries in the coming months. The Fed is playing a very dangerous game. The consequences of losing this game and having the bond market blow up in their face cannot be understated. Those expecting the Fed to sit idly by as rates rise are bound to be surprised.

Much of the data obtained for this article was found at the The Federal Reserve Bank of New York's website. You can visit the site here.