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Not Merry Twistmas

Reposted from an email bulletin- I’m finally back up to speed after my trip back from my summer base in Canada to base camp FL. Yesterday I posted a Wall Street Examiner Professional Edition Fed Report update. This is an excerpt from that report. 

The Fed’s security holdings rose in the week ended 10/12/11 by just $0.6 billion, net (versus $22-25 billion per week during QE2). None of the Fed’s GSE holdings matured. There was no net change in MBS holdings. The Fed’s $10 billion of MBS purchases in the past 2 weeks won’t start settling until November.

The Fed continued Operation Twist, with purchases of longer dated securities offset by sales of short dated securities. These operations are a wash for the primary dealers (PDs) and for the system as a whole, so there’s no need to go into detail on the amounts, which in round numbers have totaled roughly $9 billion in purchases and $9 billion in sales per week. You can find the particulars of the daily operations at this link.

Since the day after the Fed announced the program the 10 year yield has risen roughly 40 basis points. So much for pushing down yields at the long end. Of course, the announcement was well telegraphed for a month in advance, so there was massive front running with yields heading down. Once announced, bond traders sold the news, and have kept selling.

The market has begun to choke on the additional Treasury supply dumped on it by the  foreign central banks (FCBs) (see Treasury update). This is a major sea change as the FCBs, instead of absorbing massive amounts of new Treasury supply are now adding to that supply by disgorging the paper they are holding. On top of that, except in weeks where the Primary Dealers must absorb newly issued supply, there have been signs that they are dumping Treasuries across the entire spectrum. That was not supposed to happen, but we had seen in the Primary Dealer data for months that the dealers were positioned wrongly when the big rally in bonds began. Goldman Sachs’s just released earnings have confirmed these indications.

(10/2/11) The Fed has posted FAQs on the MBS replacement purchase program here: It will post a new schedule of purchases on October 8. It also states that, “For the period from October 3 to October 13, the Desk plans to purchase approximately $10 billion in agency MBS.” Those purchases will be directly from Primary Dealers.

The Fed has scheduled MBS purchases of $22 billion in the period of October 14-November 10. This is in recognition of the increased rate of MBS paydowns from its balance sheet due to increased refi activity in the wake of the sharp drop in bond yields in August and September. Prior to that, the MBS paydowns were occurring at the rate of about $10 billion per month. As rates rise, they should recede to that level again, and the Fed’s purchases from the PDs will follow.

The Fed reported that it bought $5.2 billion of MBS from the Primary Dealers on October 6-12. However, these purchases and $4 billion purchased the week before will not settle until November and December and will not show up on the balance sheet until then. Likewise, the cash won’t hit Primary Dealer accounts until then. The exact settlement dates are not published.

This means that October will be a severe dry spell for the dealers, since they won’t be getting new cash from the Fed until November. It may partly explain why they were selling so heavily in September. This is unlike the Treasury purchases under the previous MBS replacement program. The Treasuries settled the next day.

With yields having reversed, mortgage rates have begun to rise again. This will shut off the flow of refis that had spurred the recent increase in MBS paydowns from the Fed’s balance sheet. Given a lag of about 60 days from refi application to funding, MBS paydowns will begin to recede and the Fed’s replacement purchases will begin to be reduced in December, cutting the cash to PDs to negligible amounts each week. By the same token, even the $22 billion scheduled for this month is insufficient to fund new Treasury supply, especially with foreign central banks now adding to supply, rather than absorbing much of it as they had for the past decade (see Treasury update).

Recent History (7/26/11) That is grossly insufficient for helping the Primary Dealers absorb all of the new supply. They and the markets have been saved by the “miracle European panic” that has sent cash cascading from Europe into the US financial markets and banking system. As long as this continues the Fed won’t need to consider QE3. At some point, that panic flood will subside; either because it is exhausted or the news in the US will have become so bad that capital will begin to flow out rather than in. We’ll keep an eye on our financial indicators for any sign of that.

(9/9/11) I have expected MBS paydowns to increase sharply in response to a wave of refinances triggered by record low mortgage rates causing another refi wave. My take was that the Fed’s Treasury purchases would fall short of covering for that and its balance sheet would shrink a little. So far, paydowns have increased only slightly. Refi applications surged in early August. Funding of the new loans should result in paydowns increasing later this month or early in October. However, the refi boomlet has been sputtering. It’s not clear that it will have a major impact on the Fed’s balance sheet.

MBS paydowns should continue to expand as the recent surge in refinances driven by the crash in mortgage rates gets processed through to settlement over the next couple of months. When rates rise, the surge will recede. The Fed should increase its purchases to offset the MBS leaving its balance sheet, but again, the impact should not be material relative to the level of net new Treasury supply which should be between $100 billion and $150 billion per month.

The Fed estimates the MBS paydowns in advance and schedules POMO to replace them on the balance sheet. The POMO are Treasury purchases from Primary Dealers, even though they were not the holders of the MBS. But the amounts are immaterial in relation to the new Treasury paper the dealers must absorb each month.

In conclusion, the money flow data suggests the Primary Dealers will not have enough extra liquidity to throw a big Twistmas party in the stock market this year, unless that money is funneled out of Treasuries. If stocks
rally, Treasuries will suffer. There’s enough scared money still flowing from Europe into US system to support a rally in one market or the other (stocks or bonds) but not both – short of a visit from St. Nicholas. If the capital flow out of Europe into the US ebbs even a little, it’s game over for both bonds and stocks.


There’s been quite a bit of economic news over the past few days. I will pass along my comments to you as I continue to get caught up with the data. It’s good to be back, and I look forward to communicating with you regularly. Feel free to pass along any questions or feedback. I am always interested in your thoughts.


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