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The Unintended Consequence of Open-Ended QE


A look at the rising risk of actual volatility.

When Bernanke kicked off the QE II discount at Jackson Hole in August 2010 the ensuing reflation correlation whereby the dollar fell and both stocks and commodities rallied was the easiest trade in history as the market was able to ride this trend for a specified period of time. Bernanke in fact bragged about the positive effects QE II was having on stock prices even though it was only a game of speculators. What he didn't brag about was the massive imbedded short volatility position by virtue of the implied USD carry trade. Due to the negative impact that rising commodity prices was having on consumer spending, the Fed decided not to extend the program, and when they turned off the printing press, the easiest trade in history was no more and the reflation correlation they engineered blew up in their faces.

Now in an MBS market that is also short volatility, investors are facing this uncertainty at every turn. No one, not even Bernanke, knows how many bonds the Fed will buy or how long the program will last. But the market will be forced to make that determination upon each incremental data point.

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 10YR yield rose dramatically as the curve steepened on the back of a rising inflation discount. The 10YR coupon during those months was in the 2.625% range. Today the 10YR 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 100bps rise in the long end of the curve, you are talking about a massacre in market prices.
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