A few weeks ago we first reported what, according to Bill Gross, the upcoming QE episode may look like: namely a version of Operation Twist from the 60's in which the short-end of the curve -arguably the 2 or 3rd year point- is locked, resulting in a record steep yield curve while allowing ongoing bond monetizations to proceed. While that is a useful frame of reference, a far more relevant observation is what the man in charge of the world's largest bond portfolio -none other than the FRBNY's Brian Sack- has to say about what the future of QE holds, which he conveniently has done in a speech to Money Marketeers today titled, "The SOMA Portfolio at $2.654 Trillion." In addition to the future of the Fed's SOMA, Sack shares some other much needed information such as the trading details of the QE program from the view of the Fed, his perspective on the QE2's strengths and weaknesses, and his overall assessment of the program's effectiveness. Not to mention his admission that the Fed now carries 200% more interest rate risk than it should...
First, for those who lived and died by the daily POMO for 8 months, here is how Sack breaks it down:
Over the life of the program, we conducted 140 outright purchase operations to meet the directive set out by the FOMC. That meant that we were active on nearly every day possible over that period. In those operations, the Desk bought $767 billion of Treasury securities, which included the $600 billion expansion of the portfolio and $167 billion of reinvestments. Our operations ranged in size from just over $1 billion to around $9 billion, with an average size of about $5.5 billion.
Those operations brought the amount of domestic assets held in the SOMA portfolio to $2.654 trillion. The current directive from the FOMC instructs the Desk to continue to reinvest the principal payments on all domestic assets held in SOMA into Treasury securities. Thus, the amount of assets held in the SOMA will remain at that level until the FOMC decides to change the directive.
Of course, the portfolio at these levels is unusually large. In the absence of the asset purchase programs, the size of the SOMA portfolio would be around $1 trillion, as required to meet currency demand and other factors. Thus, the Federal Reserve has about $1.6 trillion of additional assets in the portfolio as a result of its asset purchase programs.
The SOMA portfolio also has different characteristics than it would have had in the absence of the asset purchase programs. Most notably, the overall duration of the SOMA portfolio at the end of June was over 4½ years, compared to its historical range of between two and three years.
For those who are still wondering who the largest holder of marketable US debt is, here it is:
With the completion of the program, the SOMA portfolio
holds about 18 percent of the outstanding stock of Treasury securities. Our
share of the market is even higher at intermediate maturities, where our purchases
Next, Sack almost goes into a much-needed discussion of what the Fed's DV01 is at this point, but not quite as that disclosure would confirm just how tremendously precarious for the Fed's capitalization any sustained rise in interest rates would be:
the larger amount and longer tenor of our securities holdings result in a considerable amount of duration risk in the SOMA portfolio, meaning that the market value of the portfolio is sensitive to movements in interest rates. One measure of this risk that is familiar to market participants is the concept of "10-year equivalents," or the amount of 10-year notes that would produce the same degree of overall interest rate risk. At this time, we have about $1.5 trillion of ten-year equivalents in the SOMA portfolio, which is about $1 trillion above the amount that we would have under our traditional portfolio approach. The majority of this additional risk came from the expansion of the balance sheet, but the extension of its average duration also contributed significantly.
Translated: this means that even in the Fed's own view, there is about $1 trillion more in interest rate risk than normal, or about 200% more than normal. Keep in mind Zero Hedge discussed the issue of the Fed's duration risk as long ago as April 2010.
And while we will spare you the Fed's talking points on why QE has been "successful" (for Wall Street and America's corporations yes, for everybody else, resounding no), Sack does share some amusing mea culpas on where he thinks QE has been a failure:
One criticism that has been directed at the LSAP2 program is that it was unable to restore vigorous growth to the economy. I think this is a reasonable observation but not a strong criticism. It is true that the support to growth provided by the asset purchases appears to have been countered by other factors that have continued to weigh on growth. However, the LSAP2 program was never described as such a potent policy tool that it could ensure a return to robust growth and rapid progress toward full employment in all circumstances. [or any]
Despite its limits, the expansion of the balance sheet was seen by the FOMC as the best policy tool available at the time, given the constraint on traditional monetary policy easing from the zero bound on interest rates. The willingness of the FOMC to use this tool is indicative of a central bank that takes its dual mandate seriously and does what it can to deliver on it. The disappointing pace of recovery that has been realized since then suggests that the additional policy accommodation provided by the LSAP2 program was appropriate.
Since when? And on to another counterfactual: re-read the last bolded sentence and tell us if it makes any sense, because it sure does not to us.
Then Sack goes on to describe how in his view the transition from QE2 to a semi-free market has transitioned. We were surprised that we does in fact recognize that since June 30 there has been abnormal vol in the bond market (something we demonstarted earlier) although naturally he does not blame it on the Fed incursion and then withdrawal from the market, but on external factors:
The pace of the Desk's purchases fell back sharply at the end of June, as we moved from expanding the portfolio to simply reinvesting principal payments. In particular, our purchases slowed from an average pace of about $100 billion per month through June to an anticipated pace of about $15 billion per month going forward. We do not expect this adjustment to our purchases to produce significant upward pressure on interest rates or a tightening of broader financial conditions, given our view that the effects of the program arise primarily from the stock of our holdings rather than the flow of our purchases. While there has been considerable volatility in Treasury yields over the past several weeks, we attribute those movements primarily to incoming economic data and to broader risk events.
What precisely would change Brian's perspective on this we wonder: MOVE hitting an all time high in the next week or month? Or will Greece be blamed for that too? Or maybe Bush.
Yet most importantly, and the core topic of this post, is what he says next about what QE3 will look like. To wit:
Given the considerable amount of uncertainty about the course of the economy, market participants have observed that the next policy action by the FOMC could be in either direction. If economic developments lead the FOMC to seek additional policy accommodation, it has several policy options open to it that would involve the SOMA portfolio, as noted by Chairman Bernanke in his testimony last week. One option is to expand the balance sheet further through additional asset purchases, with the just-completed purchase program presenting one possible approach. Another option involves shifting the composition of the SOMA portfolio rather than expanding its size. As noted earlier, a sizable portion of the additional risk that the SOMA portfolio has assumed to date came from a lengthening of its maturity, suggesting that the composition of the portfolio can be used as an important variable for affecting the degree of policy stimulus. Lastly, the Chairman mentioned that the FOMC could give guidance on the likely path of its asset holdings, as the effect on financial conditions presumably depends on the period of time for which the assets are expected to be held.
Alternatively, economic developments could instead lead to a policy change in the direction of normalization. The FOMC minutes released last week provided valuable information on the sequence of steps that might be followed in that case. The minutes indicated that the removal of policy accommodation was expected to begin with a decision to stop reinvesting some or all of the principal payments on assets held in the SOMA. If all asset classes in the SOMA were allowed to run off, the portfolio would decline by about $250 billion per year on average over the first several years.
Try as we might, we don't see the Fed doing much of any normalization considering the miserable failure to offload the Fed's pithy holdings of AIG's Maiden Lane II securities almost broke the RMBS market. But good luck to the Fed.
What is important is that Sack did in fact confirm that the Gross envisioned "Operation Twist" whereby a combination of new purchases and maturity adjustments is most certainly possible. Therefore the only open question is whether he will also be right that Bernanke will announce this expansion during this year's Jackson Hole meeting. Keep in mind the last time the economy was growing as poorly as it is now, and when unemployment had taken another major inflection point higher, it took about 20 days for the Fed to mobilize its LSAP powers.
There is about a month until this year's meeting in Wyoming.
Link to full Brain Sack Speech