Data Diary

How the POMO works – Treasuries and the fat kid who won’t play fair

Posted on 29 September 2010

We have been following a simple gameplan that says buy risk when the government is stimulating and sell when the stimulus effects begin to fade. The key barometers for this view have been various leading economic indicators (ECRI, OECD etc). These have been weakening for some months (latest OECD here) with the markets trading sideways across this period.

But ever since Bernanke spoke at Jackson Hole (here), there has been growing conviction that the Fed is about to evoke the second coming of quantitative easing – and that it will be at least be to the tune of $1 trillion. This would be in addition to the reinvestment of the proceeds of maturing MBS that the Fed has been stuffing back into the markets since August.

While there has been no authorative announcement on QE2, the comments from the Chairman and his colleagues are suggestive that this action is close at hand (a neat summary by Calculated Risk here). Additionally, the uniformity of the message being delivered across informed commentators is consistent with an administration and its quango managing information flow by innuendo. The balance of market opinion, as measured by equity prices, has QE2 as a backable event.

So for the purpose of this analysis, let’s assume that the consensus view is right and the Fed will ramp up into QE2 (subject only to a possible timing constraint around the Congress elections).  Does this qualify as government stimulus – and is it then a buy signal?

What kind of stimulus is the POMO?

Leaving aside the emergency liquidity measures that were initially installed by the Fed, the purpose of ‘unconventional monetary policy’ in Brian Sack’s words (who runs the POMO for Fed – here) is:

The LSAPs (large scale asset purchase programs)…were intended to support economic activity by keeping longer-term private interest rates lower than they would otherwise be.

How is this achieved? Again over to Brian:

For Treasury securities, the reduction in yields would occur through narrowing the term premium, or the expected excess return that investors receive for their willingness to take duration risk. By removing a considerable amount of duration through its asset purchases, the Fed has kept the term premium narrower than it otherwise would have been. In addition, the purchases of mortgage-backed securities remove prepayment risk from the market…With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.

In summary, the POMO is intended to stimulate the economy through lower long term interest rates which in turn drive money into riskier assets. If we can’t get the blighters to borrow then at least we can force them to take on more risk with their existing capital.

When the real economy doesn’t matter

QE achieves its objectives because the Fed can dominate capital flows – at least over the short term. This is not to say the objectives include stimulating the real economy. The Fed itself noted that QE has little impact on the real economy in a staff paper published in July 2010 (here). The mechanism to spurring economic recovery is then a market driven one. Whether its hoped that the lower long term rates ultimately translate into real investment, or whether it’s a wealth effect created by the general repricing of risk that does the trick is a little unclear. To Bernanke, purchasing Treasuries should simply “promote financial conditions supportive of recovery”.

But then does it matter anyway? The explicit objective of the policy is to promote a repricing of risk. If the question is do you buy risk assets then, it may pay to heed to that objective. At the very least we must try to understand whether the Fed can actually achieve this goal – and what are the risks of them not.

How successful was QE1 in bidding up risk prices?

Consider the following chart overlaying the period of POMO mark I with the performance of the S&P500.

And then a comparison of the performance of the Barclays (nee Lehman) High Yield Bond index (JNK) and the S&P500.

If there is a substitution effect that arises from the Fed sucking government backed securities out of the market and replacing them with cash, we could expect corporate bonds of all shades to benefit. However, it remains a mystery (to me at least) as to exactly how the purchase of a Treasury Note from a Primary Dealer is transformed into a contemporaneous bid in equities.  Still the evidence of price alone seems compelling.

Logic supports the idea that the seller of a security may wish to rebalance their portfolio post the exchange of that security for cash as they have lost both yield and duration.  In this regard, I found this chart from the Commitments of Traders reports interesting:

Note the first shaded patch – that covers the period from the commencement of purchases of agency securities and takes us through to the last MBS purchase at the end of March 2010.  Through this period the commercial accounts were progressively net longer 10 Year Treasury Note futures against non-commercial shorts.  This makes some sense if the commercials were hedging short ‘portfolio’ positions – whether they be from selling Treasuries, Agency debt or MBS.

If you consider that Treasury yields rose consistently across the same period, matched by commensurate rises in open interest, then perhaps this portrait of the market balance makes some sense.  (Although, given the Fed’s primary objective was to reduce long term rates, it begs the question where rates would have been without their help. But that is for another day.)

With the completion of QE part 1, commercial accounts drifted back to a market neutral position. Still open interest climbed as the Treasury bull market roared on – coincidentally as the effects of fiscal stimulus faded and fears of the double dip emerged. That is until now – the second shaded period begins with the latest purchases of Treasuries by the Fed:

The point here is that flows in one market can be expected to influence those in others – particularly those markets that offer ‘substitutes’. If the Fed has the whip hand on their Primary Dealer’s fixed interest portfolio’s, then maybe they can again steer risk markets in toto.

Conclusion

Okay to circle back – what do we know about quantitative easing then:

1) That the bidding up of risk assets is an explicit objective

2) That it seems capable of achieving this objective

At face value then, the answer to our question ‘Does this qualify as government stimulus – and is it then a buy signal?’ is Yes.

But, more importantly perhaps, what are the risks of the Fed failing in its objective. I’d offer the following caveats:

1) QE works best in a stressed market – the Fed has noted this and it seems intuitively sensible. The current market could not be categorised as ‘stressed’. This means that there is a considerable risk to the assumption that the Fed will simply announce they are going to buy $Xtrillion in securities.

2) Is the current rally in anticipation of QE2 or is it the result of the current POMO? This is a question about what size of intervention is required to drive risk markets higher.  Again logically, the more expensive the market, the more securities that need to be acquired. This is important, as it maybe that the market is now long and getting longer in anticipation of a QE2 announcement that may not deliver on these expectations. The balance of probabilities suggests it would be prudent to wait until the Fed makes it announcement before leaping into the void.

3) The Fed is not alone – Money printing is proving popular globally and, as the world’s reserve currency, the Fed is not the only actor that determines the relative liquidity of the USD (and Treasuries). Witness the recent intervention by the Japanese. If competitive devaluation becomes a reality, then the impact of the Fed’s actions on risk markets is diluted.

4) The Fed’s QE bid is, ultimately, a finite proposition.  Bernanke notes that there are (probably) limits to the strategy is his Jackson Hole speech. “The expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions.” If we are to follow the Fed, then we’ll want to keep in step when they inch towards the exit…whatever the reason.