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QE Not Working Out as Planned, but Hey, I'm Just a Caveman Economist


The Fed and pundits are declaring QE victory based on employment and rising stock prices, but correlation does not mean causation.

The so-called negative convexity exhibited by MBSs sees prices rise less as yields fall, and fall more as yields rise. This dynamic causes leveraged MBS holders to hedge this risk by buying duration when yields fall and selling duration when yields rise. You can see how this negative feedback can exacerbate moves in the bond market, especially at extremes.

In order to lower home financing costs to spur housing demand, the Fed announced they were going to buy what amounted to the equivalent of nearly 100% of net new supply. The initial market reaction was to push MBS yields to record lows and spreads over Treasuries collapsed to near zero. The effect was that a market that is short volatility was put in a very volatile position. In other words, contrary to QE II that just focused on accommodation in a relatively benign liquid part of the yield curve, in QE III the Fed exchanged policy accommodation for increased bond market price risk.

MBS Spreads

As I warned right after QE III was launched on October 1, 2012 in The Unintended Consequence of Open-Ended QE:

The last element of increased volatility is the fact that the market is loaded with very low long duration coupons. When the Fed actually launched QE II in November 2010 the Street was locked and loaded to hit Bernanke's bid and the 10-year yield rose dramatically as the curve steepened on the back of a rising inflation discount. The 10-year coupon during those months was in the 2.625% range. Today the 10-year coupon is 1.625% adding to the effective duration and making it more sensitive to a move in interest rates. If we get a comparable 100 bps rise in the long end of the curve, you are talking about a massacre in market prices.

So you have a market that is short volatility facing a potentially very volatile environment. There is the nature of the volatility in the incoming data and how the market calibrates the discount of the ultimate size of the QE program. You have the changing inflation implications in the data's effect on the size of QE and that impact on the yield curve. Then there is the reflexive relationship of the negatively convex MBS market and the added inherently volatile low coupon long duration assets. Taking all of these ingredients together and Bernanke is cooking up a witches' brew of market volatility.

When the Fed made it clear that tapering was in the offing, I again sounded the alarm that this market price risk was about to rear its ugly head in Welcome to the Dark Side of QE: The Yield Curve Adjustment Process:

What I think gets lost in the discussion about the cost/benefit of QE, and more importantly, how long it has gone on, is the fact that there are billions of potentially very volatile long duration, low coupons on the balance sheets of investment portfolios…. Due to the nature of these low, long duration coupons, the adjustment process is likely to be very chaotic, making last week look like a game of tiddlywinks.

By focusing on the mortgage market the Fed made a grave tactical error. The benefit to the borrower in lower interest rates is cost to the investor in lower coupons. Due to negative convexity in the MBS market, this cost/benefit trade-off is exponential. The benefit of refinancing a few credit-worthy borrowers from 4.5% to 3.5% had the net effect of swapping MBS investors out of 4.0% coupons into 3.0% and 2.5% coupons. To the passive participant that doesn't sound like such a big deal, but in the bond market that is flooded with negatively convex negative coupons it is a major risk factor. In so doing they made the market much more price-sensitive to the inevitable rise in interest rates.

The Fed viewed this interest rate risk as negligible because by drinking their own Kool-Aid they believed the stock theory would continue to hold interest rates low regardless of how much flow they continued to buy. Now we know this stock theory is wrong and the market and economic consequences could be severe.
No positions in stocks mentioned.
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