Did you know that the Fed was meeting this week? After a highly anticipated September meeting, where the Federal Open Market Committee (FOMC) surprised us by not altering its long-term asset purchase program (better known as quantitative easing), few analysts expect any kind of new information out of Wednesday's FOMC press release.
Indeed, since the Fed's Sept. 17-18 meeting, the labor market data have been mildly disappointing, and the federal budget situation remains precarious. Lawmakers are unlikely give us any clear resolution until December or January. If the Fed wasn't ready to "taper" in September, it won't do so now.
However, I am wondering if the market is starting to become overly sanguine on the duration of the Fed's QE program. Over the past six months, not only have we watched Treasury rates fall, we've also seen credit spreads come back to 52-week lows, mortgage-backed securities' spreads tighten dramatically and stock prices rise. I'm increasingly hearing that Janet Yellen is an uber-dove and that it is now QEnfinity.
There are two big problems with this view. One is practical. The Fed is rapidly running out of bonds to buy. The Fed's ownership of both Treasuries and MBS is reaching problematic levels. In the chart below I have projected the Fed's ownership of all Treasury bonds (blue), GSE-backed MBS (red) and Treasury bonds maturing four years and longer (green).
The Fed and Bonds Outstanding
Federal Reserve, SIFMA
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These trends make a number of assumptions: Treasury issuance by maturity continues along the same pattern seen so far in 2013, MBS net issuance goes to zero (currently it is slightly negative), the Fed keeps buying only Treasury maturing four years and longer, and overall purchases continue at today's pace. So take these specific percentages with a grain of salt, as any one of these assumptions might not be exactly correct. Still, I believe the overall picture is accurate. The Fed will soon own such a large percentage of its target bonds that the market will no longer function properly.
And keep in mind that the Fed likely wants to cut its QE purchases slowly, in order to assess the impact of the reduction in stimulus. In other words, it probably wants to go from $85 billion to zero over a period of nine months or so. Thus, it needs to start relatively soon before this chart becomes reality.
Also, the growing belief is that QE isn't particularly effective. This charge has been lobbed not only by more hawkish and monetarist economists but by many of Yellen's fellow New Keynesian economists, such as Michael Woodford or Peter Diamond. Indeed, I am confident that if the FOMC thought it could cut off QE purchases right now without signaling anything about the future for interest rate policy, it would do so. It can't, so it won't. But I strongly believe that that is where the FOMC's head is at.
All this is to say that people are being way too sanguine about how long QE is going to last in its current form. What if Congress comes up with some "small bargain" on the budget that pushes any kind of debt-ceiling argument out for a year or more? Could the Fed taper in January? Absolutely. More immediately, could Janet Yellen make some less-than-enthusiastic comments about QE in her Senate confirmation hearings? The trading in both Treasuries and corporates, especially high-grades, is very one-sided. Usually that means it is time to line up on the other side.