Street to Treasury on QE

The Treasury Borrowing Advisory Committee met on November 3, the same day at the Fed’s QE announcement. I’m not sure who the “presenting member” is who made the following comments. They are all fat cat bankers and big hedge fund types. Here’s the list: I thought the minutes of the meeting had some interesting thoughts on the Fed’s move.  The most significant observation is that QE just shortens the average life of the public debt:

The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.

Okay, let’s put this issue to bed. Whatever benefits (if any) QE may bring us could have been accomplished without the Fed. Treasury could have just changed the mix of its debt issuance and substantially eliminated sales of 10+ year coupons for a year or so. Changing the mix would have had the impact of starving the long end of supply and therefore have kept long-term rates low. The problem:

The Fed and the Treasury are independent institutions, with two different mandates that might sometimes appear to be in conflict.

Yeah, Fed and Treasury are different. But this is a case where we need to elevate the debate to a level above both of those organizations. This is not going to end up being bad for the Fed or bad for Treasury. It is going to end badly for the country as a whole and for all its citizens. So there is no conflict between Treasury and the Fed. The conflict is with the Fed and the people.

I was struck by this comment:

Members noted that the Fed was essentially a "large investor" in Treasuries.

The Fed is an investor? That’s a funny use of the word. The Fed electronically creates money and then uses it to buy bonds. But this is equivalent to buying something with 100% leverage. When you buy something with 100% debt you don’t really own it and you are not an investor. You are just a short-term player. The conclusion:

The Fed's behavior was probably transitory.

I doubt there is anything “transitory” about the Fed’s move. What they are doing will end up being a permanent increase in their holdings. There will be nothing transitory about it. But the advisory committee sees it different and thinks they should not alter their debt issuance as a result of Fed POMO:

Treasury should not modify its regular and predictable issuance paradigm to accommodate a single large investor.

A “Big Investor” sounds like a good thing. But really it is a pain in the ass. The big players have a seat at the table and often dictate policy. Ask Carl Icahn. Or better yet, ask the Chinese. They were big investors in Agency Bonds. So big, they forced Treasury to functionally guaranty $6T of paper. The Fed being a big investor is a significant disadvantage to the country as a whole. That will especially be true when the bonds come due and they have their hands out and saying “Sorry Charlie, no roll over”. Don’t expect the Fed to be benevolent when inflation comes roaring back. When the Fed is forced to tighten, it is Treasury (AKA the taxpayer) who will pay the biggest price.

The presenting member thought that over the medium term (one to two years), QE2 would force Treasury yields lower and would likely lead the curve to flatten in the five- to ten-year sector. Meanwhile, the risk premium in 30-year bonds would likely increase given concerns about inflation and the value of the U.S. dollar.

The risk premium on the 30-year has been widening ever since QE was announced. As the program unfolds there will be more weakness. The 30-year is, and will be, the ultimate measure of the success of QE, not the S&P. I think it is headed into the crapper.

The presenter further noted that rate volatility will decline as market rates approach zero, with realized volatility in the long-end remaining higher as uncertainty and re-inflation fears increase.

Traders only trade things that are volatile. If they don’t move you can’t make money. So future market angst will be taken out on the long-bond. A consequence of QE is going to be some wild price action in the long end. Good for traders, bad for confidence. Speaking of confidence how about this warning of things to come.

The member noted that there was the potential for an extreme market reaction associated with the Fed's exit from potential purchases.

Extreme market reaction? It will be a blowout that will take 30% off the equity indexes in a short period of time. Rates will back-up so quick the economy will tank. It’s likely that when this happens we will suck down a good portion of the rest of the world too. The foreign CB’s already hate QE-2. Wait till Bernanke tries to reverse direction. There will be a hell of a howl.