QE and the Bond Market
March 22nd, 2009 9:25 pm | by John Jansen |A faithful reader and frequent commenter (always cogent) raised several points on Friday regarding the results of the FOMC to launch the ICBM of Quantitative Ease into the market. Reader Greg posits that with the Fed setting the price of government bonds that the functioning of the market will be seriously impaired . I will post all of his comments and invite others to join the debate.
I think a succinct statement of Greg’s position is that the Treasury market is now rigged with the Fed stepping in a buyer.My simple response is that the $300 billion of Treasuries and the $200 billion of agency debt that the Fed will purchase is insignificant relative to the size of the markets. As an example, the Treasury will auction $98 billion of 2year,5 year and 7 year notes this week. So the $300 billion that the Fed has stated that it will purchase essentially covers this weeks series of auctions and the same series of auctions in April and May. That does not seem to be enough to me to irreparably harm the market.
I feel the same way about the agency market.
However, I do worry about the mortgage market. The FOMC has promised to purchase $ 1.250 trillion mortgages. I think that will foster a decoupling of the MBS market from the Treasury market as the FOMC will be buying a very substantial chunk of new production. I envision a situation in which even small back ups in MBS yields elicits buying from traders for non economic reasons. They buy because they know that they have a free option from the central bank.
I will post the three comments which reader Greg submitted last Friday:
By Greg on Mar 20, 2009 | Reply | Edit
John — since Bernanke has pretty much shut down the government bond markets, and has definitely destroyed all sense of market price discovery; is there any point in reporting spreads anymore?
Like you, I have watched b-fly and spread levels for years to get an indication of credit and economic activity… but as prices are now officially set by political decree, the spreads have little if any meaning
The Agency – Treasury basis has no meaning anymore — the prices of both are set by committee.
I have enjoyed your blog over the years, and I wish you continued success. But it would appear that the bond market is not going to be the place to be the next few years.
I know the mess of the markets the last few days is the immediate effect of Bernanke’s QE shenanigans — but I fear it will not be temporary. The bond vigilantes are all retired, and now it is only a question of when China will realize they have been had.
The government’s spending plans are truly something that we would expect from Hugo Chavez, not a competently run economy.
By Greg on Mar 20, 2009 | Reply | Edit
John– I agree there are still lots of things to trade, but not US Treasuries. The casino has officially announced that the games are fixed so that no customer will ever win. I don’t want to play in such a casino.
I was really saying that a spread to a politically determined price/yield has zero economic meaning
The Treasury market has no investment basis to it anymore. You are right that you can still trade it anyways — you can also trade on a roulette wheel or the roll of a dice. Neither of those has any investment merit to them. But more crucially, you have to be a fool to trade/bet on a loaded dice.
Bman — you are right that they said “up to” $300 billion. As Bernanke discovers just how foolish this announcement is, I suspect the reality will be a very small percentage of that… but the damage is done.
Once the US government officially announces that the debt market is a ponzi scheme, it won’t really fix things if a while later they are forced to announce “just kidding!”. The credibility is already lost
By Greg on Mar 20, 2009 | Reply | Edit
I would love to hear John (or whomever) explain how bid/ask spreads are going to remain anything close to what they were… if a market maker can lose 5% at the whim of a politician, that has to get reflected in a much wider bid/ask
Investment funds… if the market becomes less liquid, then it becomes much more difficult to create alpha. Without liquidity, arb trades become much more risky. How do you do a b-fly trade if you can’t sell short? If you can sell short, the haircut will have to be much much bigger (and thus the trade much less profitable). And if you make a directional bet, you need a much bigger move to overcome the wider spreads if you are right (and if you are wrong your losses will be bigger).
Essentially the Treasury market becomes buy and hold to maturity — and you don’t need lots of traders or PMs to do that (or bond blogs)
As for pension funds… HA! I would love to hear how anyone thinks they can defease 7% liabilities with a bond that yields half of that. Unless you have a liquid market, active trading isn’t going to make up the other 4-5%.
Most of the government bond markets around the world are FAR less liquid than the US. Even mighty Germany had a failed auction a couple months ago. The US used to be (past tense) the lone exception. Probably not anymore.