According to Bloomberg data, average agency mortgage-backed security (or MBS) issuance for 2012 is $133.3 billion per month. Given that the issuance has accelerated due to record low rates, you could probably attribute at least a third of this issuance to refinance. (I'm not an MBS expert so I'm purely speculating.) This prepayment could increase and essentially feed on itself if the Fed continues to keep rates where they are. So with the Fed's purchases of $40 billion of monthly purchases of MBS, this is conservatively only about half of the new origination.
Compare this to the Fed's QE2 programs of buying Treasuries; during the average month, the Fed was purchasing the entire supply of 5-year notes, at about $90 billion total per month. (I looked at May 2011 and it was $101.4 billion, but there were reinvestments included.) From peak to trough during QE2, the 5-year note moved 137bps from 1.03% to 2.40%. The mean move was about 100bps. QE1 and QE2 were also targeted more on the front end of the curve. QE1 and QE2 were focused on the 2-year to 10-year maturities, whereas Operation Twist has been targeted at the 6-year to 30-year maturities. If the Fed chooses to continue balance sheet expansion at the pace of $45 billion per month when Twist ends, it will be targeting the same maturities of Treasuries -- otherwise, it will be admitting that it has failed. And that is more damaging to the Fed's credibility, which is something we may have seen a sneak preview of with the Bank of Japan's decision to increase asset purchases yesterday.
During QE2, M3 (using the reconstructed formula from nowandfuture.com
) went from -5% MoM to +12%. Today, the Fed is buying all of the supply in the 30-year bond (99% during my sample month of May, but I rounded up), but its purchases are balance sheet neutral, hence dollar positive.
chart courtesy nowandfuture.com
So in terms of money supply growth and inflation expectations, it's much less compared to past QE's, for now. Not to mention the fact that there is the incalculable effect of diminishing returns. Because the Fed's balance sheet is so large and the fact that these tools have already been used before, their effect will be smaller. The Fed's balance sheet has grown from about $900 billion before the mortgage purchases before QE1, to $2.2 trillion before QE2, to the $2.8 trillion+ it is today. Also, because many of the assets that the Fed is targeting -- such as stocks, corporate bonds, mortgage bonds, and Treasuries -- all have nominal prices at record highs, the effect is further diminished in my book.
If the Fed wants to have an actual "nuclear effect" like it did during QE1 and QE2, it needs to ramp these purchases up to $150 billion+ to have a similar effect. During QE1, we had just come off the biggest credit bubble burst in history; during QE2 the system was still stuck in much of the same quagmire. Now, these conditions are quite the opposite, and banks are still holding back on lending out to consumers. Have you ever touched a hot surface? It hurts, right? Next time you were around something hot, you remembered not to touch it, right? The same could be said for the banks -- they just went through the grinder, and the ones that got spit out on the other end remember what it was like.
One thing I did want to point out was something Vince Foster brought up in his weekly article
on Monday that is somewhat contrary to what I've laid out above. If rates get moving higher in a hurry, this could be very dangerous to Treasury investors. If you are investing in Treasuries in the current environment, you are doing so for the return of
capital vs. the return on
capital. The on-the-run 10-year note has a coupon of 1.625%, and a duration of 9.16, so if 10-year rates were to rise to 3%, you would lose about 13 points
of principal from the current price. This is even larger in the 30-year bond. Pretty obnoxious for a safe asset.
However, given the current search for yield, I don't think we'd ever get that far, but it's nice to know for perspective. My first stab is that the 10-year yield could rise to a mid-range of 2.15% in the next six months if the Fed expands its balance sheet at a rate of $85 billion per month once Twist ends. Twist is currently $45 billion per month in Treasury purchases. This is because the Fed owns much more of the long-end, thus the "move from safe assets to risky assets" will be more muted. But I'm more concerned with how the market digests QE3 in the near-term. Overall, the move by the Fed reeks of panic and desperation.
No positions in stocks mentioned.
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