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:

  1. 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.

  2. 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

  3. 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.

  4. I would love to hear readers thoughts as I think he is thought provoking.
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  1. 21 Responses to “QE and the Bond Market”

  2. By mike on Mar 22, 2009 | Reply

    correct me if I’m wrong, isn’t that the typical beginnings of bear market. Liquidity dries up? Especially dangerous as the massive issuance continues…

  3. By Nick Rowe on Mar 22, 2009 | Reply

    People bet on what the government will do. Always have, always will.

    But I think it is more important than ever to focus on what is happening to bond yields. Paradoxically, QE creates two opposing effects:
    1. The direct effect, that increased Fed purchases of bonds increase demand, raise price, and reduce yield.
    2. The indirect effect. If QE is expected to work, and restore confidence, increase real investment, and reduce fears of deflation/increase expected inflation, private demand for bonds will fall, bond prices will fall, and yields will rise.

    So I am watching this blog more closely than ever, to try to figure out when the second effect will kick in, and how we can separate the two. TIPS spreads? Any direct evidence of expected future yields? Anomolies along the curve, between those the Fed is buying and those it is not buying?

  4. By Tom Lindmark on Mar 22, 2009 | Reply

    Thanks for posting this. I read Greg’s comments on Friday and found them compelling. It was helpful to hear a counterpoint.

    I understand your logic but I wonder how much the market might be swayed one way or the other by expectations. It may be $300 billion of Treasuries today but what might it me tomorrow if economic curve balls come their way? Uncertainty isn’t a good friend of markets.

  5. By tekewin on Mar 22, 2009 | Reply

    The effects on the bond market are just the front end of the QE wave. When the extra trillion makes it into the general economy, we should see a rise in prices, starting wherever the bond and MBS sellers spend it.

    1 Trillion new dollars is more than a 10% increase in the MZM (9411 B last I checked). It’s impossible to know if those dollars will find their way into wages, restore lost jobs, or ignite inflation. They might just drive up commodities instead, leading to an inflationary depression. This seems like Ben’s big gambit.

  6. By Greg on Mar 22, 2009 | Reply

    Hi John — thanks for posting this, I am curious as to what others think. One clarification that might be needed after your post:

    While I understand that $300 billion is small compared to the total Treasury market, it is a huge number at the margin. As a percentage of daily volume, as a percentage of what gets regularly traded as opposed to purchased and “parked in a vault” somewhere. At the margin, $300 billion could easily swing the market

    Second, I agree with Tom Lindmark’s comment that its $300 billion “to start”. We were all assured that the $29 billion backing for JP Morgan / Bear was a one off thing — and after spending hundreds of billions already, this weekend Geithner is talking about over $1 trillion. If Bernanke’s meddling is “successful” — from a political, not economic viewpoint– then $300 billion will be just the start

    Third, lets be honest here: part of the reason Bernanke is doing this is to put a floor on Treasury prices to placate the Chinese government. We can’t afford to upset the people crazy enough to lend to a spendthrift has-been world power. In other words, the correct figure is not $300 billion- it is “whatever is needed” to make sure China does not have to show a loss.

    Both the 10yr and 30yr moved a full 5 points after the announcement — suggesting the market does not think the Fed’s behavior will be insignificant

    Lets say you are a market maker in Treasury bonds, every time you do a trade, your book is temporarily unhedged- it remains unhedged for a few seconds to a minute or so. Nothing new there, just stating the obvious.

    If during those few seconds/minute, the Fed decides to jump in with a few billion in purchases — your P&L for the quarter could be wiped out or doubled (depending on your unhedged position). The Fed obviously cannot pre-announce its trades, so it will be a surprise. How can any trader not consider this rather important new risk?

    A trader could go long in the inside market, then sell to the customer later (thus avoid ever being short) — but that isn’t risk free either, and basically is a long winded way of charging a wider spread.

    Wider b/a spreads, a flatter curve, greatly increased political risk — there is lower hanging fruit elsewhere

    Also, I don’t think any of the spreads / b-fly levels we have all watched for years will be very helpful going forward. 2y-10y spread doesn’t have any economic meaning if both prices are set by political committee

  7. By John Jansen on Mar 22, 2009 | Reply

    Greg,

    I guess I do not buy the Conspiracy theory vis a vis the Chinese.The relationship (or whatever you style it) with that country is symbiotic. They need an overvalued dollar as much as we need them purchasing our debt.If the dollar tumbles, it will have severe consequences in their domestic economy as demand from the US will nose dive (more than it has). So I would argue that we also have leverage to use against them.Or it is certainly not in their self interest to torch the dollar.

    Regarding the Fed and its purchases of Treasuries. The details are being hammered out but it is certainly possible that they will pre announce purchases. They do that in the agency purchases now. I don’t think they do it for pass thrus.

    And if the Fed does not pre announce the risk would not be inordinate. The 5 point move which you spoke of repriced the market for that. So the risk on an individual operation of several billion is minor. There is certainly risk but I think that you are talking 32nds and never points.

  8. By John Jansen on Mar 23, 2009 | Reply

    VIA CREDIT SUISSE

    We favor buying the market on setbacks and look for 10-year yields to reach 2.35% in the near term. Realized and implied volatility will continue to decline as the yields are increasingly managed by the Fed. We see scope for flattening in the long end, as we expect that the Fed will make some purchases in the bond sector despite a focus on intermediates. We continue to favor being long cheap off-the-runs on ASW and high coupons versus low coupons. The Fed will primarily purchase off-the-run securities, in our view.

    AND THIS

    Treasuries
    The Fed’s decision to purchase $300 billion of Treasuries is appropriate, in our view, but it is relatively small in size. However, we believe it will be expanded or extended if necessary. We reiterate our view that cheap off-the-run Treasuries on an ASW basis will benefit greatly from the buyback and think high-coupon bonds in the 2016 to 2023 sector offer value versus on-the-runs. Additionally, cash should outperform futures, in our view, as the Fed will be buying Treasuries and not futures contracts.

  9. By SD on Mar 23, 2009 | Reply

    The chief problem with QE, as I see it, is that one become exposed to jump / event risk. It becomes very difficult to trade, as one announcement/action by the central bank causes prices to gap (up or down). Over multiple runs, these jumps cause a serious erosion of P&L.

    Further, the central bank action pegs the yields at a level, which the market deems uneconomic. So no one wants to buy those levels and the market bids are at yields way above the QE determined level. At the same time, no one wants to sell at the higher market bids, as there is always the possibility of further central bank action gapping the yields lower.

    All these forces, result in a reduction in risk appetite, increase in bid/offer spreads and a drying up of liquidity. Taken to its logical extreme, the market ceases to function.

    IMHO, QE is a strategy prone to failure. You can’t rig prices and still call it a ‘market’.

  10. By Dr.Dan on Mar 23, 2009 | Reply

    What is expected issuance of treasury in 2009 ? Close to 2 trillion ?

  11. By Dr.Dan on Mar 23, 2009 | Reply

    SD:
    “IMHO, QE is a strategy prone to failure. You can’t rig prices and still call it a ‘market’. ”

    Yes, this is exactly what Greg is arguing.

  12. By Mike on Mar 23, 2009 | Reply

    The Fed will never limit its purchases to $300B. All the programs get larger and this one will not be an exception. I think it’ll be $1.5T to $2T by the end of the year.

    I agree with John on the relationship with China. This isn’t done for China and China has its own issues.

    I agree with SD on the substance of QE. You now have to make two bets when you place a trade: what the market will do AND what the fed will do to the market.

    This is not helpful. I trade equities and did so through the short-ban last year. It was a nightmare trying to game what was going to happen next and how it would impact the markets.

    During and just after the short ban, there was a massive decrease in arbitrage activity. (It still hasn’t returned to pre 9/15 levels.) I expect the same thing will occur in the gov bond markets now.

    Who wants to be holding any positions into the next fed meeting when they gapped 5 points in the last one?

  13. By will postlethwaite on Mar 23, 2009 | Reply

    I write this from the perspective of the UK gilt market where it all began with such euphoria that Bernanke decided it was a great idea too.

    Firstly the gilt curve shows the hideous dislocation caused by artificially rigging prices. The 5-25yr belly sags and the slightly less than 5 year auction last week almost failed. The end result of this, I agree with others above, is a drying up of liquidity meaning the central banks will have to buy everything.

    Secondly I believe QE is actually about two things, making govt bonds so unattractive that you have to buy something else (or as might be the case put it in the mattress) and making interest rates in your currency unreflective of the risk of holding it such that foreigners flee to more realistic risk/return and drive your fx down and your competitive advantage up. Competitive devaluation or protectionism by the back door. They are all at it.

    The medium to long term consequences however are horrendous. As mentioned above, what hope pensions when long yields are such a bad investment. A supreme punishment for the prudent and the companies pension funding problems. Also when the buyer steps away and necessarily becomes volte face a seller what price yields when 1-2 years record issuance looks for a home in 24 hours. How do you manage that? surely we will have a grinding halt in the economy yet again.

    All I can see coming out of QE is huge future instability. Unrealistic prices are always unsustainable. It is all economists academic musing but they are never right and have never understood the real world, only history.

  14. By Leo on Mar 23, 2009 | Reply

    Greg,

    Japan has the most ridiculous market (if you call it “market”) in the world. Bank of Japan set the first QE and started buying bonds years ago. Since then, the interest rate of 10yr government bonds has not seen more than 2%. It touched 0.4% once. It’s not the interest rate anymore.

    But there are still bond markets working more or less in Japan. The reason why investors still buy government bonds is that there are no alternative assets to buy. They know it, but cannot stop buying. It’s a dull market, anyway.

    More ridiculous is that Japanese government is buying stocks. They buy stocks and bonds, but (or therefore?) still markets are depressed.

    I’m not sure US markets are going toward Japan’s, but there may be some risk of “degenerating into Japan” in the US.

  15. By Juan Motime on Mar 23, 2009 | Reply

    Greg has become my favorite blogger at any site I visit. I learn more from him than anyone’s comments I read anywhere.

  16. By Greg on Mar 23, 2009 | Reply

    John, Apologies if I made it sound like there is some sort of Chinese “conspiracy”… I am only saying that every business needs to be acutely sensitive to the wishes of its largest customers; even if that business is a government. Many kings in history had to be careful not to upset their merchant class (the ones who paid the taxes and made the castle work). The US Treasury is hoping to issue trillions in new debt over the next few years, and China has not been quiet about wanting assurances. This is not a “conspiracy” — its just common sense not to tick off your biggest customers

    I found the comments from the UK gilt / Japan markets particularly instructive. I hadn’t even thought about that angle — but the descriptions given are exactly what I fear will happen in the US.

    Is there still a JGB market in Japan? No doubt. But Mrs Wantanabe has her money outside Japan. The JGB futures market is practically shut down. While Eurodollars and Euribor futures are super liquid — Mexican Cetes show far better volume than Euroyen.

    Real market prices for US treasuries are roughly 5% lower than Bernanke’s politically mandated prices. When a central economic planning authority sets prices — by definition it is not a market.

    Medium / long term – politically set prices cause shortages and/or resource misallocation. They cause slower economic growth, and hence lower tax revenue (the stuff needed to service the debt). This time will not be different.

  17. By Dr.Dan on Mar 23, 2009 | Reply

    Greg for 2013

  18. By John Jansen on Mar 23, 2009 | Reply

    Greg,

    You are developing a following!!

  19. By John Jansen on Mar 23, 2009 | Reply

    And I would be remiss if I did not thank you for your fine work.

    I dont know if you read “Naked Capitalism” but that widely followed blog linked to this discussion.

    So you are moving the blogosphere.

    Thanks for stimulating intellectual palates.

    JJJ

  20. By Al on Mar 23, 2009 | Reply

    Bernie, I mean Bernanke will be regretting about that decision for the remainder of his life, just as Greenspam about his own misdemeanours. But what a shame, we cannot change the past.

  21. By westslope on Mar 25, 2009 | Reply

    ” if a market maker can lose 5% at the whim of a politician, that has to get reflected in a much wider bid/ask”

    A minor point perhaps. The risk premium should increase; the bid/ask will only widen if disagreement increases.

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