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How To Front-Run The Fed's Upcoming SOMA Limit Increase
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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Think 'exit strategies' because everyone else is.
i could not help but notice that no prediction for stocks was offered under scenario 2 !
We're going to see a minimum of $1T - less than that the market will be upset. $1T or more and we'll see a triple digit Dow rally. IMO.
Oh right, so the Q/E number was always $1 trillion as Goldilocks 'just right', whatever happened to those far higher estimates back in last August when the DOW was at 9,900 and $4-$7 trillion was being thrown around to get indexes up off their deathbeds for a nice 10% ramp? Bernankes Open Mouth Committee sowed a few free seeds, fertilized with a bunch of hype and generous bullshit and got a bumper 10% equitycrop. Mission accomplished and Ben knows its game over.
Theres a whole lot of people wanting to have their cakes and eat them too these days!
Now Harry concludes $1T is some kind of 'just right' number....LOL we'll see.
I believe TD is right in the long run, but I can see a scenario where the Fed disappoints until the market BEGS for a ultra-massive QE3.
I always enjoyed a good Soma Coma...the pharmaceutical kind
and what are the chances that Uncle Benny, just for shits n giggles, tells the good serfs out there, that we will do what is necessary to support blah blah blah, and not give a number, all the while knowing that he will ramp up his pomos.... everyone shits a brick and panics, and he gets to buy at discount...at least for a few minutes.. this is all fun and games to him, he has the keys to the presses....
In the book, soma is a hallucinogen that takes users on enjoyable, hangover-free "holidays"
http://en.wikipedia.org/wiki/Brave_New_World
SOMA = system open market account
Clearly, the concept of "irony" is lost on the Fed.
...Or not.
Yen is making new highs.
Japan's deficit is much bigger than ours percentage wise.
I don't know why the Fed doesn't just do $5 trillion QE2.
That is sure to send bonds into Outer Space and cause a gargantuan rally in the U.S. dollar.
Why is everyone so worried?
More total ignorance from RoboTrader as usual, Japan is completely different from the US in every way you can think of, savings rate, general philosophy of the people, manufacturing, etc.
But Robo cant see anything past his stupid stock boner charts.
Again Robo, which CNBC or FED personality are you?
The pitchforks and torch crowd are gathering in the town square. Ben's Open Mouth committee has worked its magic for three months, sow the soil with a few nickels and some rhetoric and get a bumper crop of equities in return. Hope you all enjoyed the fun. But Ben is no fool, he sees what is coming and knows the party is over. Geithner will be gone by the end of the year, and IMO the days of "accomodation" are over.
Thats just the way I see it, there were lots of BIG numbers discussed in late August to get markets off their deathbeds, at least 10% lower than now...and $100 billion in treasury purchases wasn't the promise back then not by a long shot!
Sweet 16 spoiled brat market was promised a Ferarri and will get delivered a used Civic....you really think thats going to go over well? I dont.
Tales of $4 trillion, IMF rumor of $7 trillion, now we're supposed to believe a few token monetizations of some long bonds will make all stocks oh so gleeful and provide RoboTrader and Harry with more stock boner charts to marvel at? Bunch of bullshit is what it all is!
Old sows like Art Cashin are about to get run over and trampled by the young ones.
Akin to seeing Archie Bunker playing one on one against Kobe Bryant.
Or Mark Haines running the 100 yard dash with his pants down around his ankles against Usain Bolt.
Lots of fear in the market today, everyone is expecting the big disappointment and the "end of the world as we know it"...
LOL...
Yea we'll see about that soon, phony stock pumpin cheerleader. So which CNBC chick are you really, humping on Zerohedges leg during commercial breaks....Erin or Melissa?
same as before, I totally agree but I really think the initial denial will allow for the mega QE that sheeple beg the fed for. Translation, lots of mega volatility for the elite to ride down then up and out and into PM's. I know this 'cause I added an extension to my tinfoil hat last night see, so I just know shit now....its great, and fun at parties.
And while Robo makes money, the sheep gets sheared.
Hey, he might be but for me - I gotta go with "early, not wrong".
You have not seen the running for the exits all at once before have ya. I'm not talking about a flash crash recovery either. Beware of being overly confident at these levels with the illusions of markets like this one in particular.
The fear seems to have emanated from the bomb scare and not QE2.
So does this mean TIPS are SOL losers? Just want to be sure so double checking.
You I am sick of investors like Harry just being manipulated into doing what teh FED wants...buy stock and front run bonds lowering rates. YOU ARE WHORING YOURSELF FOR THE DESTRUCTION OF THE DOLLAR LEADING TO HYPER INFLATION AND UTIIMATE DESTRUCTION OF THE MIDDLE CLASS. No one has discretionary income there and high inflation will amount to a huge incremental tax. You people are immoral sell outs and you disgust me udderly.
you made my day..udderly..had a flash back to milking cows..lol. I needed that. but share your sentiment. but, don't hate..be thankful, somebody's gotta hold the shit bag..just be glad it aint you. it's an experiment..a movie as that bitch put it..one that is ending with real life implications. i'm just waiting for a los pepes type group to come forth from this new 'nana republic. (I wonder if they would need a clerical type to do fascimiles and keep the front desk tidy?)
I think gold and silver will do fine in scenario 1-2 and even do OK in 3 short term. In 3, expect a dollar panic and a sell off in everything as the margin man comes back. Gold, in the delflation will catch up to the dxy in 3 months.
3 is absurd since it's counter to any of the dogma that monetarists and Keynesians understand.
I' m betting on 100% mediocrity- neither a bazooka hit or a full hawk. The market will rally with the orchestrated news and Pomo, and maybe as the economy goes back into the reality tailspin bonds will rally as well.
Basically, what we have today is as good as it's going to get.
Bonds cheap to float, low yields, more printing.
Money funneled back into stock market to prop up the facade of real wealth.
Dollar sags to like 75, but since we are deflated it stalls on descent. And then there's Europe.
I've been in bonds in my kids account for the last year knowing bernanke isn't going to let the bond market get more expensive for his fantasy game plan. Everyone who has been calling for yield explosions is about 5 years too early.
In the end, he will fail to stop the depression and we are in this for a lonnnnnng time.
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