Flash Point: The Limits of QE3

The primary tool of the Fed for affecting the economy has been its ability to manipulate interest rates. Lowering them has traditional stimulated the economy promoting recovery. With the current recession, the Fed first lowered short-term rates to effectively zero. When that didn’t work, it tried Large Scale Asset Purchases (LSAP) or quantitative easing (QE). These programs effectively reduced longer term rates with each successive program working further out the yield curve to the 30-year bond. This has not worked. In the process, the term structure of the Fed’s Treasury portfolio has been altered dramatically as this video from Stone McCarthy shows:

Having lost all leverage at the front of the yield curve (short-term rates) it can only play at the back end, the longest-dated maturities. Moreover, we see that the Fed has very little left of shorter-term Treasuries to sell if it wishes to sterilize the purchase of longer-term Treasuries.

But more importantly, a study by UBS via Zero Hedge (The Scary Math Behind The Mechanics Of QE3, And Why Bernanke’s Hands May Be Tied) indicates the Fed doesn’t have much room there left to work.

the Fed owns all but $650 billion of 10-30 year nominal Treasuries.” Also as pointed out above, Twist 2, aka QE 3.5 is already absorbing all of the long end supply. And herein lies the rub. To quote UBS: “Taking out, say, $300 billion in long-end Treasuries almost certainly would put tremendous pressure on liquidity in that market….Ploughing ahead with a large, fixed size QE program could cause liquidity to tank.

This raises The Dilemma of the Impatient Trader. If it attempts an LSAP of long-dated Treasuries, it first of all may not find enough to create the stimulus effect it would like to, and second of all, would wildly distort markets with an unknown but likely disastrous effect.

UBS then goes on to explain why, if the Fed wanted to but mortgage-backed securities (MBS), it is limited to about $40 billion per month:

The alternative of tilting purchases toward MBS implies that the QE program would need to be quite protracted. Monthly supply of conventional 15yr, 30yr and 30yr GNMA has averaged about $85-90 billion over the past year and the Fed is already buying about $25 billion. The Fed might be able to buy another $40 billion without disrupting the market.

The result is that if the Fed wishes to implement a QE3, it has very real limits on the amount of securities it buys and the rate at which it buys them. And operating in markets where it is the largest player will mean the premium the Fed pays as an impatient trader may be huge.

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