The Fed, QE, Rates And You


I made this point in a couple of Tickers, and in the presentation last night.  It’s grossly contrary to “mainstream” opinion, and I want to explain it.

Now of course things can change, and only a fool doesn’t change his opinion when the facts underlying it turn out to be different than expected.  But with that said….

The Fed will cease QE on schedule.  The taper is not only on, it won’t be suspended.  And, withdrawing liquidity, that is, allowing short rates to rise, is on the table too, and almost-certainly sooner than you think.

It doesn’t matter if the market sells off, even if it sells off hard.

Here’s why.

If you remember I have repeatedly pointed out the utter insanity of QE in the first place.  It is much like snorting heroin — you get a high immediately but the price is spread out.  That’s for the simple reason that bond portfolios work that way.

In other words, with the possible exception of a few small individual “investors” who buy a single bank CD, nobody (in their right mind anyway) buys just one bond.  This is particularly true of large investment pools and those who underpin the bond market, such as insurance companies and pension funds.

All of these entities ladder their bonds.

If you’re unaware of how this is done, it’s simple — the people who buy these things want a more-or-less “constant duration” because they are intending to meet some expected expense with the interest coupon.  They attempt to match that duration against their perceived risk, and adjust for interest rate environment both today and what they expect tomorrow.

So let’s say that after much grinding of numbers Insurance Company “A” determines it needs a 10 year duration in its portfolio in order to earn the return it wants, hedge the risk it wants, and match the two against incoming cash flows and expected claim payments.

Starting out (when the company is formed) it thus buys a set of bonds that look more or less like this:

10 year bond, 1 year to maturity.
10 year bond, 2 years to maturity.
10 year bond, 3 years to maturity.
and so on.

Now they might mix some stuff up in here too; if you think the curve is going to steepen (that is, long rates go up more than short) you would prefer to buy a 5 year bond with 3 years to maturity over a 10 year one, all things being equal (but of course they never are because the yields at those two times of issue were almost-certainly different!)  The point, however, is that what you end up with in the portfolio looks like this:

10% has 1 year to maturity.
10% has 2 years to maturity.
And so on.

By the way, individual investors with a lot of money do this too. It’s very popular among muni investors, for example, provided you have enough money to make it work (six figures for starters, on up) because individual bonds are typically sold in $10,000 increments and if you have enough to capital to do it you can pick exactly what risks you want as opposed to buying a mutual fund where someone else makes those decisions.

So now The Fed comes in and does QE, buying the long end.  What happens?  Long rates go down.  A year on your 1 year to maturity bonds mature, and you must replace them.  With what will you replace them?  All things being equal, when you replace them you will get less interest income from the new issues.

So let’s say the effect of QE is that your mortgage goes from 6% to 3%.  This is a 50% reduction in your interest payment.  But — that MBS gets sold into the market.  MBS have a typical maturity profile of about 7 years (which is why the 10 is the benchmark; it’s the closest), fluctuating somewhat.  When rates are high and falling the profile is shorter (because people refinance), when rates are low and going higher it extends (because you’re a nut to refinance a 3% loan into a 4% one — nobody does that unless you have to sell and move for some reason.)

So the guy who buys it gets a 50% reduction in his interest income, but that’s only 1/10th of his portfolio.  For the first year, anyway.  As such his impact the first year is 5%, then 10%, then 15% and so on.

We’re roughly five years into this crap now.

The pension funds and insurance companies that are the backbone of this market are probably doing plenty of screaming, and with good cause.  If this keeps up their cash flow will collapse; they can’t absorb it.  Further, Bernanke and the rest of the Fed know that factually the damage they took on by buying those instruments during QE cannot be gotten rid of either; it has to roll off, because if you sell that bond you’re going to take a capital loss and crystallize the entire loss right now instead of spreading it out!

This is what is forcing the end of QE.  It is also what is going to force The Fed to pull liquidity and let the short end come up.

They don’t have a choice but they will never breathe a word of this, because to confirm it would be to give a clean opportunity to gang-bang all those bondholders by Hedge Funds and others who can play in the derivatives market, and that could (read: probably would) set off a crisis far worse than 2008.

That’s my read on it.

We’ll see, over the next months, if I’m right.

The Market Ticker

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