Guest Post: Front Running the Fed

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Served by Jesse from Le Café Américain

I had a friend from the old neighborhood who was the Comptroller of a major casino in Las Vegas in 1970-80s, where I also was married in 1981. Only lasting win from there, ever.

According to this dour son of Italy the way he could spot a problem, besides the more aggressive methods of observation and detection, would be to examine the returns on a table basis. In the short run they will vary, but in the longer term each game will provide a statistical return that rarely deviates from the forecast, unless someone is cheating. We would walk through the casino, and he would point to a table game and say “at the end of the month, this table will bring in xx percent.”

It was he who introduced me to Bill Friedman’s book, Casino Management, which is a useful read if you wish to learn more about that end of the speculative business from the house perspective.

Attached is some information from a reader. I cannot assess its validity, not being in the bond trading business. But it does sound like someone has tapped into the Fed’s buying plans to monetize the public debt and is front running those buys, essentially ‘stealing’ money from the public. Its what they call ‘a sure thing.’

To try and figure out who might be doing it, I would look for some big player who is showing extraordinary returns on their trading, with consistent profit that is not statistically ‘normal,’ too consistently good. The problem with cheaters is that they sometimes get greedy and call attention to themselves.

In Las Vegas the bigger cheats were often taken out into the desert for further inquiry and final disposition. On Wall Street they are somewhat more arrogant and persistent, defying resolution with that ultimate defiance, “We’ll just find other ways to cheat again.”

Time for a trip to the desert?

Here are a reader’s observations from the bond market.

From a reader:

I used to work for a BB on a prop desk until the financial crisis took hold and they fired the less senior guys on the desk. I now trade US Treasuries, for a small prop firm in xxxxx, to scalp basis trades in mostly on the run securities. Occasionally, I will also take position in the repo markets for off the runs if I see something “mispriced.” Your recent article piqued my interest because we too have noticed “shenanigans,” of sort, in the QE program of USTs.

What we noticed, especially in smaller issues like the 7 Year Cash is that before a Fed buy back would be announced the price would pop significantly as buyers would run through all the offers on two major electronic exchanges (BGC Espeed and ICAP BrokerTec). This occurred more than several times as the 7 Year Cash would be overvalued both by its BNOC by 20-30 ticks and its relative value to similar off the runs. This buyer(s) would lift every offer they could, driving the price substantially above its “value” for sometimes a week at a time. After this buying would occur, the Fed would then announce the purchase of that security sometimes a handle above its approximate value. This “luck” did not just occur in the on the run 7 Year sector, it also occurred in the 30 Year Cash, 3 Year Cash, and more than several off the runs. Again, it was especially prevalent in the less liquid treasury products. Often the “appetite” for these securities would begin approximately 2 weeks to 1 week before the official Fed announcement. The buying was well organized and done in such a way as to completely knock it off kilter from its relationship with like cash Treasurys and the CME Ten Year Contract. If you examine the charts of some of the selected buy backs before the official announcement, you will see a similar occurrence.

While I have not broken this down into a paper to prove it (and I see nothing positive coming out of contacting the ESS-EEE-SEE about this issue), I can assure you that it was occurring on a consistent basis across the entire curve.

A certain issuance would be bid up through the market (substantially above value, as derived by several metrics) only to be later gobbled up by the Fed at the unreasonable price. These player(s) had substantial pockets as we, the small guys (but with a decent capital base), would take the other side of what seemed to be an obvious fade. While this did not occur in every single issuance of the QE program, it occurred often enough to be obvious to any learned observer.

While I am not sure if this can be attributed to purposeful Fed policy or someone at the Fed talking to his pals, I am certain it transpired.”

Corruption is inevitable when the government is engaged in manipulating the markets with public monies. That portion of the Fed’s activities needs to be scrutinized by the GAO on a continual basis. And the activities of the Exchange Stabilization Fund and the Treasury in market intervention should be subject to review by the legislative branch on behalf of the people.

Of course another option is to keep the Fed and the Treasury out of the public markets altogether excepting short term interest rates and specifically identified emergencies.

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  1. Don Smith

    In a market where the Fed’s plans are so telegraphed and transparent, is this even unethical? Would you be dumb not to take advantage of this if you have the buying power? It’s possible that the Fed wouldn’t do the repo, right, so there’s risk (albeit negligent at this moment in time).

    The only corruption would be if the Fed had staffers (or Directors) calling BD’s in advance and saying, “Here’s next weeks CUSIPs.” Beyond that, haven’t the moves been clear enough that pretty much anyone could front run them if they were smart enough to realize that the mispricing wasn’t abnormal in this manipulated market?

  2. Jesse

    No Don. You are not reading it correctly.

    The ‘moves’ on specific issues are NOT telegraphed ahead of time to the general market. Obviously.

    That is the difference between speculation and genuine front-running.

    If it was obvious to everyone, it would not be an issue would it, except that the Fed then would be obviously buying at non-market pricing, providing a largesse to a greater number of traders at the expense of the public.


  3. Thomas Barton, JD

    Jesse, good to see you at Yves’ site. You are too kind to the perpetrators of this. There needs to be a Special Prosecutor appointed to hammer away at the situation you describe. Also, I wish you had a comment setup as here which I think would make your site even more enjoyable.. Yves has her antidote du jour and I really enjoy the art posters on your site. Go to Vegas and have some fun at the house’s expense ! Cheers.

  4. Jesse

    There is a certain connotation of ‘insider trading’ of the deliberate leak of privileged information.

    Front running is what one does with insider information. But one might also obtain information from other sources, some market inefficiency for example, that might not be technically considered ‘insider trading’ per se.

    And yes I am being very understated in this. The facts such as they are represented second hand to me are there, and will be understood by anyone who understands the markets.

    It is a suspicion. It would take investigation to turn it to fact.

  5. psychohistorian

    I feel compelled to keep asking, where are the folks going to jail or even being prosecuted for these transgressions?

    With the latest SC ruling we are mainlining fascism now and only those that protest will be treated poorly.

    1. claire

      “I feel compelled to keep asking, where are the folks going to jail or even being prosecuted for these transgressions?”

      IMO, they won’t. I don’t think the government has the resources or the expertise to even conduct a competent investigation, quite frankly.

      “With the latest SC ruling we are mainlining fascism now and only those that protest will be treated poorly.”

      I am in a very tiny minority here, but I don’t think you are reading the implications of the SCOTUS decision properly.

      My view is that it is Congressional incumbents that are going to use the new ruling to extort ever more money from businesses, with the threat that there will be lots of unpalatable legislation passed if the businesses don’t cough up. A little bit of cash here and there can only sway elections if the electorate is somewhat undecided. In this case, as Ma showed, they aren’t undecided so much as they are mad as hell at the lack of justice (or whatever other word you want to use that represents their views).

      So Congressmen will get re-elected by passing laws. The efficacy of those laws will depend upon how much lobbyists want to cough up. With less limits on how much to cough up, the price of buying a Congressman will basically shoot up.

      Sure, the results aren’t going to be any better than if businesses had more control, but the shift in power is significantly different from what most people are anticipating will occur.

      Incidentally, I notice the banks aren’t declaring the end of the world and the collapse of the financial system if a any more legislation is passed contrary to their interests. It looks like they’ve either struck some deal with the Obama Admin and this is all for show, or else they know that they are too unpopular to say much without risking a lynching.

      I suspect they are too stupid to know their unpopularity, so…

  6. wunsacon

    Jesse, you don’t enable comments at your site. But, since you just read some comments above, let me take this moment to say, basically, um, “I love you, maaan.” Like Yves, you’re one of my daily reads.

  7. xav

    This is our only chance to get rid of Bernanke. Please call the undecided senators in the list below. Yves I hope you don’t mind for this.. if you do please remove.

    – LEVIN, Carl (D-MI) phone: 202-224-6221 Fax: 202-224-1388
    zipcodes if asked – pick one Lansing:48906 thru 48919 except 48914 Flint: 48501 thru 48507 Grand Rapids:49501 thru 49510 Farmington:48331 thru 48336 Holland:49422 thru 49424 Kalamazoo:49003 thru 49009 Traverse City 49684 thru 49686

    – MIKULSKI, Barbara A. (D-MD) phone: 202-224-4654 Fax: 202-224-8858
    zipcodes if asked – pick one Baltimore:21209 thru 21218 Ocean City:21842-21843 Columbia:21044 thru 21046 Ellicott:21041 thru 21043 Silver Spring:20901 thru 20911

    – NELSON, Ben (D-NE) phone: 202-224-6551 Fax: 202-228-0012
    zipcodes if asked – pick one Omaha:68101 thru 68112 Lincoln:68501 thru 68512 Bellevue:68005

    – NELSON, Bill (D-FL)Phone: 202-224-5274 Fax: 202-228-2183
    zipcodes if asked – pick one Jacksonville:32201 thru 32212 Miama:33124 thru 33138 Tampa:33601 thru 33626 Orlando:32801 thru 32812 St. Petersburg:33701 thru 33716

    – REID, Harry (D-NV)Phone: 202-224-3542 Fax: 202-224-7327
    zipcodes if asked – pick one Las Vegas:89101 thru 89157 Henderson:89011 thru 89016 except 89013 Reno:89501 thru 89513

    Note that MIKULSKI and REID are running for another term. Those 2 really need our attention.


  8. Skippy

    Thanks Jesse as always, although a lier deluded or not is unabashed till consequences take out their front teeth for all to see.

  9. joebek

    The question is: Were only securities eventually bought by the FED run up or were all or a significant portion of securities with the described characteristics run up. If the latter we would have to say that it is only a matter of speculation on the intentions of the FED. If the former then it looks like insider trading.

  10. Gary

    Hey Jesse – great article. Central banks rarely do anything without first consulting their major counter parties – period. Remember in 2008 when the Fed widened the discount window eligibility and a number of banks in unison decided to access the window, to avoid individual shame. Have a look at the volume and movement in the Eurostoxx futures in the hours prior to the Fed announcing this. Clearly the announcement was telegraphed as the banks had already decided to access the window as one. Let me also tell you as a fact, that quite a number put on huge prop positions that down prior to the announcement.

  11. RCS

    As an international market, long term, your done. You have stolen the “equity” (trust) from your markets. You are done, long term.

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