QE2 — fail…

First of all, I’m a big fan of the Fed and in particular Bernanke. I think he saved the day in the GFC, and that things would have been much worse if he hadn’t been chairman. Also, I don’t subscribe to any of the anti-greenspan / Fed caused the Tech bubble / Housing bubble tosh …

Having said that, I do think that the Fed ought to be a little uncomfortable with the recent price action in bonds.

A little background – the Fed used to be (basically) a cash trader; thanks to the GFC the Fed’s a bond trader (as with overnight rates as low as they are willing to take them, they must get other rates lower to ease financial conditions).So, we might ask, how is their programme of bond buying going?

It’s only four days old now (the first QE2 POMO was Friday) but I think we can assess overall performance as poor. Yields been rising, and the market appears to be front runing the Fed in a massive way – the Fed consistently pays the yield low … cutting a cheque for primary dealers in the process.

It’s always been the case that lowering rates is good for bank profitability – but it’s seldom been as egregious as this. First time out was the 5yr buyback on Friday. The Fed took ~7bn of 5yrs at 1.27%; the market sold off to 1.37% right after – the 7yrs are currently 1.49%. Fail. Second hit, the 7yrs on Monday. Fed takes ~7bn of 7yrs at 2.05%, they sell off to 2.19% right after – and are currently 2.16%. Fail.

Third hit, the 3yrs on Tuesday. The Fed takes ~5bn of ~3yrs at 81bps, market sells off to 83bps – currently 77bps. Pass — but there’s no delta in these anyways, so who cares; it’s much more more worth the risk front runing the fed  on the longer stuff.

Fourth swing, the 10yrs last night.The Fed takes ~8bn of ~10yrs at 2.81%, market sells off 2.91% — currently 2.89%. Ouch! Fail.

If QE works at all it’s by capitalising future tax revenue.  The larger the losses on the OMOs, the less effective the policy will be, as (in a ricardian world) we should expect tax payers to start saving to hedge their increased future tax liabbilities thanks to the Fed’s poor bond trading.