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Bernanke's Announcement: Badly Framed and Poorly Timed?

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The attempt to reflate the markets at all-time highs in both equities and Treasuries may start a series of reactions that are negative for both.

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MINYANVILLE ORIGINAL

Did Ben Bernanke just drop a bunker buster bomb on the markets?

Let's begin with the latest Fed announcement. The Fed's Open Markets Operations desk will immediately start buying $40 billion in Mortgage-Backed Securities (MBS) per month, or about $10 billion each week. At the same time, the Fed will continue Operation Twist by purchasing $45 billion in "longer-term" Treasuries, sterilized by $45 billion or so in 1-3 year bonds. Unfortunately, at the end of the year it runs out of short-term paper to sell.

Every month in 2013, the Fed will increase its balance sheet by $85 billion consisting of $40 billion in MBS and $45 billion in 10-30 year Treasuries, up to the natural monthly supply of longer-dated US Treasuries. It appears the Fed may monetize roughly half of the US budget deficit in 2013.

From July 2011 through June 2012, foreign holders of Treasury Bonds and notes have been purchasing $30.6 billion of longer-dated Treasuries per month. To date in 2012, the average US Treasuries issuance per month has averaged $82.83 billion per month. This leaves an average of $7.2 billion of net issuance available to banks, pensions, and private individuals. Could that be a problem?



The bond market thinks it spells trouble. On the day of Bernanke's speech, US Treasury yields spiked to 3.108% from the low of 2.663% just two weeks ago, causing a technical breakout above the previous high of 2.982%. This portends rising yields through the rest of the year -- reaching or possibly exceeding the 3.612% yield shown at the weekly mid-cycle line.

What's more, starting in 2013, new rules in the Dodd-Frank Act, designed to prevent another meltdown, may force traders to post US Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.

Is it possible that the very law designed to reduce risk in the markets may cause unintended consequences, especially after the Fed announcement?
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No positions in stocks mentioned.
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