The Fed Now Owns 27% Of All Duration, Rising At Over 10% Per Year
When it comes to diving trends in the Fed's take over of the Treasury market, there are those who haven't got the faintest clue about what is going on, such as Paul Krugman, who naively looks (as Bernanke expects all economists to) at the simple total notional of securities held by the Fed and concludes that the Fed is not doing anything to adjust fixed income risk-preference, and then there are those who grasp that when it comes to defining risk exposure in the bond market, and therefore in equities, all that matters is duration, expressed in terms of ten-year equivalents. Sadly, this is a data set that not every CTRL-V major or Nobel prize winner (in order of insight) can grab from the St. Louis Fed - it is however available to those who know where to look. And as the chart below shows, even as the Fed's balance sheet has remained flat in notional terms, its Ten Year equivalent exposure has soared, rising by 50% during Operation Twist alone, from $900 billion to $1.313 trillion. What this means in practical terms, as Stone McCarthy summarizes, is that the Fed now owns 27.05% of the entire inventory in outstanding ten-year equivalents. This leaves less than 75% of the market in private hands.
The chart below shows the total Ten-Year Equivalents in Duration terms held by the Fed, and total outstanding including and excluding the Fed's SOMA holdings. Observe the red-line which is precisely what the Fed is targeting - it shows that courtesy of Twist 1+2, there has been virtually no change in the private market constituency in 10-Yr equivalents.
Perhaps most important is the chart showing the percentage ownership of the entire bond market by the Fed expressed in 10-Yr equivalent terms. It is now at 27%, and rising ever more rapidly.
The visualization of the complete takeover by the market is even more obvious when instead of observing ten year equivalents, one tracks the simple maturity of the debt entering (the SOMA) and leaving (the private market).
And the same using Mid-Modified Duration. Once again: you will not hear Nobel prize winning economists ever discuss these concepts.
Finally, and as demonstrated before, here is a snapshot of the Fed's nominal holdings by CUSIP spread by maturity. Some may be surprised that the Fed already owns 70%, or the maximum allowed without the Fed destroying all liquidity in a given CUSIP, in various issues, primarily in the 7-10 year window.
This is how the Fed's holdings distribution looked like in a bygone age, in July 2003 when the first LSAP operation began, when things were "normal" - it will never look like this again, as the Fed will never be able to sell its portfolio into the market. After all, the Fed now is the market.
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Where are we going with this analysis? It should be rather obvious. Zero Hedge was the first to forecast what the Fed's balance sheet would look like, anticipated a $1.2 trillion increase in the Fed's asset size through the end of 2013, or a total of $4 trillion. Subsequently, Bank of America came out with a forecast of $5 trillion through the end of 2014, at which point the Fed will stop the liquidity tap.
Now it is Goldman's turn to opine.
Sure enough, the team led by Jan Hatzius who has been pushing for not only QE3 since January 1, 2012, but for NGDP and other programs that finally kill the Stock argument erroneously used by the Fed for decades, and replace it with a Flow-based approach to asset-price 'modelling', sees QEternity continuing not only into 2013, into 2014, but well into 2015. June 2015 to be precise.
...we expect the unemployment rate to fall to 6¾% in the middle of 2016. This pins down the timing of the first rate hike for mid-2016 as well, a year later than under the FOMC’s more optimistic view.
The corresponding projections for QE3 are shown in Exhibit 4. Under our own forecasts, we expect purchases of $75bn/month through 2013, split into $30bn/month for MBS and $45bn/month for Treasuries. By the end of 2013, we expect the committee to reduce the pace of purchases to $50bn/month, and buy at this pace through the middle of 2015—again, a year before the first rate hike. So in effect, the program proceeds at the same pace as under the FOMC’s economic forecasts, only for a longer period because the recovery is more sluggish.
Under these assumptions, the overall size of QE3 would be just under $2trn, split into $900bn in MBS purchases and $1.1trn in Treasury purchases. If so, QE3 would be three times as large as QE2, though only moderately larger than QE1. Again, the average flow of purchases would be somewhat smaller than under both of the prior programs, and the difference in size would be due entirely to the longer duration of QE3.
What this means is simple, yet tragic: the Fed will continue increasing its 10 Yr equivalents by roughly 12% (of the total market) per year, for at least the next 3 years, at which point it will own 60% of the entire Treasury market. It means that the Fed will monetize all gross long-term issuance every year for the next 3 years, while leaving the ZIRP paper, ala that maturing under 3 years, and yielding negative return in real terms to the Direct and Indirect investors with its blessings, as all sub-3 Year TSYs in inventory become the equivalent of cash (albeit with a maturity date).
Alas, since it is the Fed whose actions continue to distort the structural basis of unemployment, and since inflation is and has always been purely in the eyes of the governmental beholder, manipulated at will, it is virtually certain that the only thing that will stop the Fed in the future, is when it literally runs out of paper to buy, and has to monetize every dollar of new issuance, which at this rate will happen some time in 2016-2017.
But that will only be the beginning, as at that point the Fed, which will hold every US Treasury paper in the entire market, will simply pull a BOJ, and proceed to monetize everything else: REITs, ETFs, Corporate bonds, but not stop there and go ahead and purchase all the insolvent student loans, pension funding debt, and all other rate-based paper.
The only question is how long until this glaringly obvious endgame is priced in by what remains of the "market."
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