In the end Wednesday, the markets got just about what was expected from the FOMC and Fed boss Ben Bernanke. While a certain notable French bank who shall remain nameless (OK, it was Société Générale) came out with 70% odds of a $600bln round of new quantitative easing (aka QE3), that was an outlier view. Most folks in the fixed income and forex markets (we don’t pay much attention to the stock guys :) ) were looking for a continuation of the Operation Twist program in which the Fed sells short-term treasuries it owns and buys longer-term ones.
These expectations are why in the end the various global markets basically just continued on the course they had already begun earlier in the day, albeit with a little volatility after the FOMC statement and into Bernanke’s press conference. Following the extension of Twist, the Fed chief’s comments about standing ready to do whatever may become necessary were predictable. He’s been saying that for some time now. Why not? It’s true. It’s always true. The Fed will do what it thinks it needs to do when it thinks it needs to do it. Folks seem to read QE3 expectations into that every time he says it, though.
To that end, it occurred to me yesterday that the folks who keep calling for QE at the next FOMC meeting are kind of like the folks who set dates for the end of the world, then when it doesn’t happen they revise to a future date.
The thing that had me sure there was no QE3 coming this week was a comment Bernanke made a little while ago that he was seeing no signs of deflationary risks at present. Deflation risk was a big factor in the justification for QE in prior rounds, so if he’s not seeing that risk now, the odds of QE3 drop despite economic developments. Now, the Fed forecasts released yesterday did feature lower inflation expectations, but nothing leaning toward deflation. That will be something to watch morning forward.
At this stage, the bigger issue at hand is going to be the value of the signals coming from the Treasury market. As I wrote a couple weeks ago, the Fed already owns a large portion of outstanding long-term Treasury paper. The extension of Twist is only going to make that share grow. The bond market guys I work with say basically the Fed will be buying all of the long-dated paper the Treasury issues for the rest of the year. This is going to further shrink the “float” of long-dated securities, which could make the likes of US 10yr yields even more volatile because it will take increasingly smaller volume to move them around.
Considering how correlated USD/JPY tends to be to those rates, the higher volatility in yields could make for some interesting action in that exchange rate. Notice in the chart below how much time the correlation between the two markets is positive and how even when it turns negative it is just briefly and only marginally so. If the 10yr yield becomes less valuable as an indicator due to the Fed’s dominant holdings, we could see the relationship between it and USD/JPY breakdown.
Also, things could get interesting on the short end of the yield curve as well.
The Fed normally holds a lot of short-dated Treasury paper which it uses in open market operations to keep short-term yields in line with policy. The Twist operation has already seen a lot of that paper sold as the Fed has bought long-dated securities. The expectation in the bond market is that the Twist extension will result in the Fed not having any shorter-term paper left. That could create some interesting dynamics at the front end of the yield curve. Considering how important overnight interest rates are to currency exchanges rates, there is the prospect of some periods of unusual activity in the months ahead. As a result, it will be worth keeping track of what the Fed is doing.
This is one of those times when understanding structural elements of the markets can be important.