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To All Who Front-Ran The 35% SOMA Limit Elimination: Congratulations
As Zero Hedge predicted, the 35% SOMA limit was removed. We hope readers managed to profit from this inevitable development. Our full post from October 29 recreated below.
With the bogey of a minimum QE announcement of $100 billion a month,
leading to an in kind purchase of Treasurys, in addition to $30 billion a
month from MBS Refis courtesy of QE Lite, a very likely announcement
during next week's FOMC meeting, that nobody is talking about, is that
the Fed may raise the existing 35% SOMA limit, or abolish it altogether,
due to the imminent ceiling hit of purchasable CUSIPs. As a result, as
Morgan Stanley suggests, possibly the most profitable Fed frontrunning
trade if one wishes to bet on consensus QE, is to buy SOMA excluded
CUSIPs as these will be telegraphed to be next in line to be monetized.
Of course, in the apocryphal scenario that the Fed disappoints the
market and decides to announce a less than $100 billion a month, or,
gasp, nothing at all, MS' Igor Cashyn expects a complete bloodbath in
rates (and most certainly in risk assets). Then again, the probability
of the Fed doing the right and/or prudent thing ever is nil, so we would
focus on buying out of favor SOMA issues, because as Morgan Stanley
reports: "Net, we like buying what the Fed is buying."And how could one not: after all Morgan Stanley announces that in 2011 net Treasury issuance net of Fed Purchases will be zero!
In
terms of looking at QE, Cashyn expects three scenarios: QE announcement
of greater than $100 billion/month for 3-6 months; less than $100
billion, and no QE. Here are the three scenarios broken down.
Scenario 1: Fed Announces $100 Billion/Month for the Next 3-6 Months
Right on expectations:
Our core view is that the Fed announces a specific figure at next
week’s FOMC meeting of $100 billion / month in Treasury purchases for
the next 3-6 months. The Fed chairman has had plenty of opportunities to
back away from QE2, yet has taken none. In addition, a recent survey by
the New York Fed polled bond dealers and other investors for their
expectations of the size of QE2 along with its likely impact on yields
(as reported by Bloomberg), which we view as a preparation for just such
an announcement. Continued weakness on the inflation front, along with a
persistently high unemployment rate, should also justify QE2 from the
data front. We thus anticipate that the Fed will announce $250 billion
over the next 3 months or $500 billion over the next 6 months (keep in
mind that they are also already purchasing around $30 billion / month
via their SOMA reinvestment program).Such support would almost
certainly be seen as bullish for the Treasury market, and we advise
investors to position accordingly. That’s because the Fed’s purchasing
pace will be on track to take down all of the $1.15 trillion in Treasury
net issuance that our US economists expect for F2011, and should be
reflected in yields accordingly (Exhibit 1):
Currently,
we anticipate that the market is also expecting roughly $100 billion /
month, but what’s contributed to the sell-off in Treasuries over the
past couple of weeks is a subtle softening of the market’s call for a
substantial program to a more data-dependent, fine-tuned approach. This
has reduced the certainty of what will actually be announced, but if the
Fed now delivers on the expectation of $100 billion / month, the slide
in 10y Treasury yields should then reverse, in our view, and 10y
notes should come right back down to the 2.35–2.50% range (a 15-30bp
rally from here).Further, while it can be argued that
the implicit monetization of US government debt may ultimately prove
inflationary (in fact, we like being positioned in 10s20s inflation
breakeven steepeners to hedge this view), the initial impact on yields
is very clearly bullish, in our view. Investors who have reduced their
longs in recent weeks will add back to those longs, and other investors
that were previously on the sidelines will get back in. Net, we like buying what the Fed is buying and are bullish on Treasuries.We also think that the belly will outperform and reverse its recent underperformance, and we continue to recommend staying in 2s5s flatteners, earning
+8bp in rolldown + carry / 3-months, as we equate an expansion of the
Fed’s balance to mean that the Fed will not be hiking anytime soon.
Similarly, the 2s10s curve should also flatten.We also
think the Fed’s goal in this scenario is to drive inflation breakevens
higher and real rates lower, and TIPS investors should also position
accordingly. We specifically like buying breakevens in the
front end of the curve in this scenario (i.e., <5y sector), as any
announcement of QE2 should also be accompanied by renewed weakness in
the dollar, resulting in a rise of the $-denominated prices of
commodities, to which breakevens in the front end of the curve are most
sensitive (see With QE2 All but Certain, a Look at the Treasury Market
Implications, October 8, 2010).Fundamentally, we cannot lose
sight of the fact that QE2 is intended to inflate asset prices, and to
that end, equities and bonds should both rally. But the rally in
equities will only have a secondary effect for bond yields, which will
still be pushed lower over the near term. This is in fact what the Fed
wants to accomplish, driving Treasury yields low enough to promote
investors to get out the credit spectrum and increase the valuations of
riskier assets – but this can only be accomplished if yields stay low.
And here is the key trade that is most profitable in case of scenario 1: buy "SOMA-excluded" Cusips:
SOMA
Ceiling Rise Possible but Unnecessary (Yet): Apart from the size of the
purchases, next week’s announcement could also be accompanied by an
increase in the Fed’s SOMA limit from 35% currently to, say, 50%. The
implication of this is that Treasury notes that are currently ineligible
for purchase by the Fed (e.g., mostly high coupon bonds) reverse some
of their recent cheapening on the curve versus the low coupon bonds.
Exhibit 2 shows where such bonds are concentrated on the UST curve:
An
area of the curve where high coupon bonds are likely to outperform in
the Exhibit above include rolled-down 30y bonds in the 2018-22 year
sector (although the 2026-27 year bonds already seem to be a bit rich on
the asset swap curve).
We will compile a list of the
most convex 2016-2020 SOMA excluded CUSIPs soon and present it to
readers to determine which are the Treasuries most likely to benefit
from Bernanke's insanity.
Continuing on, here is Scenario 2, one
which will see a major move down in assets from bonds to stocks, and
everything inbetween. In a nutshell: expect the 10 Year to sell off to
2.75% if the Fed does not do monetize at a $1.2+ trillion a year
runrate.
Scenario 2: Fed Announces <$100 Billion/Month for the Next 3-6 Months
Below expectations:
A risk to our view is if the Fed tries to be too flexible in its
approach to QE2, driven by the uncertainty on the fiscal front.
Specifically, whether the Bush tax cuts get extended, as well as in what
form, may lead the Fed to hold back for now. Further, a recent article
by Jon Hilsenrath in the WSJ highlighted that three regional Fed bank
presidents – Narayana Kocherlakota of Minneapolis, Richard Fisher of
Dallas, and Charles Plosser of Philadelphia – have expressed skepticism
about QE2, and a smaller program may be needed to pacify some of this
dissent (although truth be told, they will not be taking voting
positions at the FOMC next year).In any case, we think the
Treasury market would be disappointed, leading 10y yields to rise back
toward 2.75% and the belly of the curve to underperform (as it is
directional with yields). CFTC positioning data of speculative investors
(i.e., non-hedgers) reveals that market participants are currently long
in both the front end and the back end of the curve (Exhibit 3):With
both the front-end and back-end longs at their 2-year highs, any
disappointment from the Fed is likely to drive yields higher from here.
And now, for the last scenario, one that will cause untold destruction in stocks, and is thus impossible. But here it is anyway:
Scenario 3: Fed Does Not Announce Treasury Purchase at This Time
Complete
disappointment: Fed language promises support to the economy if
conditions continue to worsen but backs away from providing any new
stimulus at this meeting. We personally view this as a <5%
probability event, a tail risk to our view if you will.In such
an event, we are likely to see a major backup in Treasury yields, with
10y notes going back to the 2.75-3.00% range. Exhibit 3 above already
demonstrated the fact that investors are long the market, and any
disappointment is likely to be met with swift selling of Treasuries, led
by the back end.
However, the one part of the curve that
we do not expect to be materially affected is the front end of the
Treasury curve, as the Fed will remain on hold for the foreseeable
future (read: disappointing inflation trends / high unemployment). Thus,
the 2s10s curve will remain directional with movements in the 10y
note, and will flatten / steepen to the above moves accordingly.Investors
should think in terms of asset inflation when evaluating the effects of
QE2 – if no purchases are announced, both equities and bonds are set to
underperform. Our certainty on this is quite high, as equities have
rallied 12% since Bernanke’s Jackson Hole speech (near their 1y highs)
and 10y yields are still near their 1y lows (Exhibit 4):
And
while some might think that an underperformance of risk assets leads to
an automatic outperformance of Treasuries, which may eventually keep
Treasury yields from rising much higher over the long-term, Treasury
yields will still sell off over the near term.
Since
this is the Fed we are talking about, whose only mandate is to keep
artificial stock price levels as high as possible, you can forget about
Scenarios 2 and 3. Which is why the SOMA trade appears most attractive.
And don't forget to fund it by shorting the carry currency of choice
these days... the dollar of course.
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Interestingly, Steve LIESman has failed to take note of this rather important point.
I'll bet he's saving it for some later time, when he will point out how necessary it was, and how wise the Fed was to remove it before the SHTF.
I hear the Fed is changing their mission statement to "All your bonds are belong to us!"
Yesterday news Tyler, yesterday news :)
THE REAL QUESTION IS: HOW WILL QE3 LOOK LIKE!!
The Fed mails us all "prepaid" debit cards?
Make mine 1T! Thanks for that!
The last paragraph is gold.
As Zero Hedge predicted, the 35% SOMA limit was removed
Why didn't I listen to Tyler...WHY?!
Good call, TD.
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