By Sheila Mullan
NEW YORK (MNI) – There is an ongoing debate in the U.S. Treasuries
market about whether the Federal Reserve will be forced to lift its own
rule barring the central bank from holding more than 35% in any one
Treasury issue.
The controversy arises amid speculation that the Federal Open
Market Committee could launch another round of quantitative easing, with
size estimates ranging from a $300-billion initial episode all the way
up to $1 trillion.
The market implication is that some traders believe if the Fed does
QE2, it will continue to purchase Treasury intermediates heavily, so
those traders are buying that zone in the hope that the Fed could lift
its own limit.
RBC analysts Keith Blackwell and Dan Grubert said, “We believe the
Fed will announce another round of QE in November” but they added that
“the question now becomes, how they distribute their purchases and when
they raise their 35% limit.”
“We believe the most likely time is the January FOMC meeting;
however, the timing is highly uncertain,” they said. The RBC analysts
added that “we expect the belly of the curve to stay rich” and noted
that “for the 6- to 10-year sector we expect the Fed to buy issues out
to the 2.75s of 5/17 until they are all at 35%.”
They went on to say that “if the Fed purchases $27 billion per
month in the 4- to 6-year part of the curve, they’ll come very close to
running out of bonds by fall 2011.” They also believes that in the long
end, the Fed will likely buy up the issues between 5/39 and 5/40 as well
as those between 8/28 and 2/36.
Blackwell told Market News this Friday afternoon that “our base
case for QE2 is around $1 trillion total size to be announced in a
piecemeal fashion. If the Fed really wants to aggressively purchase
Treasuries, they’ll have to increase the 35% limit.”
Both he and Grubert said that in this situation, the Fed has two
options; up the 35% limit or not buy as many Treasuries.
“We have long been against another round of QE2 because we believe
the possible costs far outweigh the benefits,” they said, warning that
while the economic impact of another round of purchases is uncertain, at
best, the potential distortionary effects of such a policy are quite
real.
“However, given that QE2 seems inevitable, we believe the Fed will
eventually increase the 35% limit, but don’t expect they’ll take the
limit past 50%,” they predicted. “We hope that they do it sooner rather
than later because the longer they wait the more acute market
distortions will become on both sides of the announcement.”
But TD Securities’ Richard Gilhooly eyed such Q/E2 speculation and
said “our more modest expectation is of $300 billion of Fed purchases at
the Nov. 3 announcement … with clear latitude to alter this amount in
either direction even at the next meeting, leaves us expecting no change
to the 35% self-imposed maximum of any issue that the Fed can hold.”
Gilhooly ran various scenarios for no QE (just $300 billion MBS
prepays reinvested into Treasuries), for a QE2 program of $300 billion
in addition to prepays, and for $500 billion as well as $1 trillion in
QE, with various percentages of maturity sectors the Fed would hold
using the exact distribution of the recent buybacks to allocate
purchases.
1) No QE2: He said with “no QE, but $300 billion of prepay
reinvestments would leave the Fed close to 35% in just one sector, the
10-year to 20-year sector” so “no need to change the 35% rule.”
2) With $300 billion QE2 initial size, the Fed “would exceed 35% in
both 10-to 20-year and 6- to 8- year sectors, by 5% in each sector”
3) With $500 billion QE2, the Fed “would exceed 35% by 10% in
10-30yrs and by 14% in 6-18yrs;
4) While with $1 trillion QE, the “Fed would massively exceed 35%
in 6- to 8-year by 37%, 10- to 20-years by 21% and also in 4- to
6-years, by 6%” so “the larger the size of QE the more pressing it
becomes that the Fed lift the 35% limit” on holdings, he said.
Gilhooly noted that in aggregate, the Fed has “room to accommodate
$1 trillion of QE even” at “current size of the Treasury market of just
over $6 trillion, without hitting the 35% limit overall.”
A year from now, he added, the outstanding amount of Treasury paper
will exceed $7.3 trillion, meaning the Fed would have room to purchase
around $1.8 trillion, in addition to its $754 billion current holdings
before hitting the ceiling in aggregate.
Gilhooly also said that “raising the 35% limit carries the opposite
risk of emphasizing Fed’s presence” in the U.S. government bond market,
which will worry Fed officials concerned about any perception of
monetizing the federal debt.
Instead he suggests that the Fed switch around its purchases, from
the 6-year to 8-year, to the 8-year to 10-year, or even the one-year to
two-year sectors.
— e-mail: smullan@marketnews.com, 212-669-6432
** Market News International New York Newsroom: 212-669-6430 **
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