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Bond and Stock Market Volatility Is Collapsing Post-QE3


If history is any guide, investors getting long that trade are flirting with disaster.

The consensus concludes that QE III is focused on two objectives: One, lowering mortgage rates to help spur housing market activity, and two, raising the value of risk assets by inflating the currency. I believe both of these conclusions are misplaced and could turn out to be dangerous assumptions.

As I argued in Operation Twist II: Project Escape Velocity, I don't believe Bernanke is focused on lowering interest rates to help borrowers; I think he is targeting bank balance sheets. Due to rising savings and declining loan demand, the current aggregate loan-to-deposit ratio of US commercial banks is at 80%, which is near historic lows. As a comparison, that ratio was at 100% in 2008. At the same time, the ratio of securities held as a percentage of total credit assets is near historic highs with a large chunk in Agencies and MBS. According to Fed data, commercial banks are sitting on $2.6 trillion in securities comprised mostly of $1.3 trillion in MBS and $500 billion in Agencies and Treasuries.

Bernanke is trying to flush banks out of these bloated bond positions. He has already taken Agencies and Treasury yields to levels that have essentially removed any net interest margin that a bank can earn carrying these securities. The next assets on Bernanke's hit list are MBS and it didn't take long for the market to price this into spreads. With no spread left in MBS, the risk/reward for banks to own these securities is highly inverted. Before it even got started ,QE III had virtually eliminated the incentive for a bank to buy MBS.

At the September FOMC meeting, the Fed committed to keep the bank's cost of funds at zero until 2015; at the same time, it committed to remove the supply of MBS that bank can buy. To me, the message to banks is loud and clear: Your funding costs are staying low for at least three years, and you are not going to be allowed to sit in securities and make any net interest margin. Take the $2.6 trillion in securities and go makes some loans.
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