When some deemed the Fed’s move today to expand its balance sheet by as much as a trillion dollars plus as “shock and awe”, I recalled that when that term was first used, at the beginning of the US invasion of Iraq. The notion was a display of superior force would lead to quick capitulation.
We know how well that theory worked. And I suspect the unintended Iraq-Fed analogy is apt.
Let me focus on the Treasury part of the equation, but with a recap first. The Fed announced today that it would buy up to $750 billion in Agency MBS this year (in addition to an earlier commitment of $500 billion) and up its purchases of Agency bonds from $100 billion to as much as $200 billion. It also said it would purchase up to $300 billion of longer dated Treasuries over the next six months.
As readers no doubt know, stocks took off, bonds rallied big, as did gold (note the last two are contradictory). And the general tone was that investors were surprised. Caught off guard might be the better turn of phrase. The Fed had indicated very clearly in December that it had moved to a policy of quantitative easing, sort of (as Tim Duy noted, the Fed seems to consider a commitment to continuing to expand the Fed’s balance sheet as QE. They have not taken that move, either then or now). Analysts were impatient at the Fed’s failure to announce how it intended to use the Fed’s balance sheet to improve credit market functioning, and didn’t get as much in the way of news in January or February.
But let’s consider further what is operative here.
The Fed said it was concerned that inflation was at sub optimally low rates, implying that these measures were being implemented primarily to combat deflation. But the numbers above tell what the real story is. The Fed first and foremost is trying to prop up asset prices, particularly housing, out of a view that their current level is the result of irrational pessimism. The Fed had indicated in earlier statements that it was going to target interest spreads over Treasuries of various types of credit products, and that is still by far the greatest use of firepower. However, the addition of Treasuries is a new, albeit expected, wrinkle. Let’s face it, if the long bond continues on its march to 4%, the Fed can do all it wants to contain mortgage spreads, but it become increasingly difficult to keep mortgage rates from rising.
But let’s look at that up to $300 billion over six months for Treasury purchases. Sounds formidable, until you consider how much the Treasury calendar is increasing this year.
I’ll admit I did not do extensive digging, but I found an interesting memo, “Report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee of the Securities Industry and Financial Markets Association” from early February. It isn’t too long, and it is worth reading. The SIFMA polled members on how to change the Treasury auction calendar to accommodate the increased supply coming over the next two years.
Read it closely. The memo does not say so in so many words, but the changes that SIFMA members could come up with (as in they were willing to recommend) do not appear sufficient to take up the additional supply.
And consider this cheery observation:
The net supply of Treasurys in 2009 and 2010 combined seems likely to total more than $3 trillion and could climb as high as $4 trillion. The Congressional Budget Office (CBO) estimates the 2009 Federal budget deficit to be $1.2 trillion. The consensus of private sector analysts is similar to that figure. Yet, neither the CBO estimate nor the private consensus reflect fully the funding needs associated with the Obama Administration’s fiscal stimulus plans, the implementation of TARP (or another TARP-like program), or the rumored creation of a bad/aggregator bank to help deal with the underperforming assets weighing down financial institutions. Some of the funding of these government programs will spill over into 2010, a year in which the “core” budget position also will be weak according to mainstream expectations for economic performance.Actual and potential funding needs for financial sector stabilization programs already announced are considerable. Guarantees made on select assets of systemically critical financial institutions could require Treasury to raise hundreds of billions of dollars in the event that these assets continue to deteriorate. Similarly, guarantees made by the FDIC on select bank-issued debt could catapult government borrowing needs further should the issuing bank(s) default on its FDIC-insured paper. Any additional guarantees on future losses to assets held by financial institutions would further increase net borrowing needs by Treasury. The size of any such borrowing would hinge on the type and size of assets backstopped.
The expansion in quasi-government paper contributes to the risk of market saturation. Banks have issued nearly $150 billion in FDIC-backed paper since the programs introduction. Spreads on this paper have been narrowing over time with the latest deal, paper offered by Citi, pricing just 30 basis points over Libor. Real money investors have purchased the bulk of this paper in an attempt to pick up yield over Treasurys while not taking on additional credit risk. In some respects, this paper has replaced GSE debt as the instrument of choice for real money investors looking for modestly higher yielding, quasi-government debt.
So take $1.5-$2 trillion in incremental Treasury supply per year, which SIMFA is telegraphing it expects will prove low. That’s $125-$167 billion a month. SIFMA warns there has already been some crowding out due to FIDC backed bonds.
And now we get to the other half of the equation: thanks to falling trade deficits (which require foreign central banks to park FX reserves somewhere, generally a large chunk in Treasuries), foreign purchases of Treasuries have fallen sharply. Per Brad Setser:
I wanted to highlight one trend that I glossed over on Monday, namely that foreign demand for long-term Treasuries has disappeared over the last few months….The rolling 3m sum bounces around a bit, but foreign demand for long-term Treasuries in November, December and January was as subdued as it has been for a long-time. Among other things, that fall in foreign demand for long-term Treasuries after October suggests — at least to me — that the big Treasury rally late last year (and subsequent sell-off this year) doesn’t seem to have been driven by external flows. Foreigners weren’t big buyers of long-term Treasuries back when ten year Treasury yields fell to around 2%.
FYI, by long-term, Setser means 10 year and over. And his charts show demand for Agencies and corporate bonds is pretty much non-existent too.
His charts show a big spike for T-bills in the crisis months, but Setser notes:
However, that surge in demand for bills now seems to be fading.The fall off in total TIC flows in January reflected private bill sales. The official sector is still buying — $100 billion in bill purchases over the last 3 months of data only seems small relative to the post Lehman peak. But with global reserve growth slowing (even China doesn’t currently seem to be adding to its reserves), central banks won’t be as large a source of demand for Treasuries going forward as they have been in the past…..
Why does this matter?
Foreign demand for Treasuries hasn’t kept up with Treasury issuance, but it undeniably has been strong. Over the last 12 months, net foreign purchases of Treasuries financed much of the US current account deficit….
The trade and current account deficit has fallen substantially as a result of the fall in oil prices, so the US needs less external financing now than in the past. But it still needs some.
The “quality” of the financial flows into the US consequently bears watching. A modest revival in foreign demand for longer-dated US assets would be a positive sign. To date, the sale of US assets abroad and a scramble for liquid dollar assets has provided the US with more than enough financing to sustain its deficit. Those flows though may not continue.
And if — as seems likely — foreign demand for Treasuries fades long before the US fiscal deficit, the US Treasury will need to sell an awful lot of Treasuries to American investors. For the past several years I have argued that it was almost impossible to overstate the impact of central bank demand on the Treasury market.
So $125-$167 billion of new supply a month (and SIFMA warned it could be more) and a big question mark about foreign demand means $50 billion of Fed Treasury purchases a month may not be enough to keep rates from rising. The fact that 10 and 30 year Treasury yields in Asia are higher than their lows yesterday in New York suggest some skepticism. By contrast, after the December FOMC meeting, when it announced it was doing its not exactly quantitative easing thing, bond yields fell sharply and continued to march forcefully downward over the next four days.
In addition, some of the Fed’s pet programs may not be getting the traction they want. The TALF (the $1 trillion facility targeted at fostering new lending to credit cards, auto and student loans, appears to be getting a lukewarm reception. A hedge fund correspondent had dinner with a colleague at a large hedge fund and reported that the said that the returns theoretically available weren’t high enough to make it viable, and there was no enthusiasm for the program among his peers.
And even if the Fed does win the yield battle, it may not prevail in the war. From the New York Times:
Jan Hatzius, chief economist at Goldman Sachs, said the Fed had adopted a “kitchen sink” strategy of throwing everything it had to jolt the economy out of its downward spiral.But while Mr. Hatzius applauded the decision, he cautioned that the central bank could not solve the economy’s problems by expanding cheap money.
“Even if the Fed could make interest rates negative, that wouldn’t necessarily help,” Mr. Hatzius said. “We’re in a deep recession mainly because the private sector, for a variety of reasons, has decided to save a lot more. You can have a zero interest rate, but if you just offer more money on top of the money that is already available, it doesn’t do that much.”
Anonymous 
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Great analysis Yves.
I think everyone is still digesting the implications of this, and it goes along with the 1 trillion public-private partnership you’ve been blogging about.
The last quote you had seems to convey the Zeitgeist pretty well. There’s the idea that a massive program of new lending is pretty pointless. People are waiting for some sort of new structures or industry to emerge that might justify this kind of lending. The cynics might say they are waiting for the next bubble. The usual tack of just pumping more money into the system and expecting the system to know what to do with it, doesn’t seem to be working.