It’s less than two weeks ’till the day markets expect a US QE2 announcement.
And expectations are intensifying ahead of November 3. RBC Capital Markets, for instance, expects the Federal Reserve to purchase about $113bn worth of US Treasuries per month, about the level mentioned by Dennis Lockhart earlier this week and in-line with the central bank’s original quantitative easing programme.
One small problem though.
As RBC’s Capital Markets has pointed out before — this time around the Fed will be more restricted in what it can buy. Under so-called System Open Market Account (Soma) limits the Fed cannot buy more than 35 per cent of any single issue. And for many issues, the central bank has already hit that limit, or is very close to doing so.
This Friday RBC’s Keith Blackwell and Dan Grubert ask a new but very related question: How long would it take the Fed to run out of bonds to purchase?
According to the two fixed income analysts it’s not that long.
For the six- to 10-year sector for instance, they reckon the Fed will buy issues out to 2.75s of 5/17 until they are all at the 35 per cent limit, which would take until January or February 2011, depending on how aggressively the purchases come.
As for the four- to six-year sector, as the end of this month, the Fed has only hit the 35 per cent limit in four issues, leaving about $210bn left to buy. If five-year issuance is about $33bn per month, which would add about $11bn to the pool of bonds available for purchase each month. If the Fed buys $27bn a month in the sector, it will be close to running out of bonds by October 2011, and will probably be have to satisfy themselves with buying newly-issued five-years.
As for the long-end, RBC reckons the picture looks very much the same as for four- to -six-years. If the central bank were to buy $15bn per month, the total available for purchase would decline at a rate of $10bn per month — including new issues and reopens. With $112bn currently available to buy in that sector, by September 2011 there would be nothing left but new issues and re-opens to the purchase.
The Fed — as most of the market knows by now — likes to buy USTs that are relatively cheap. So it would probably look at low coupon issues in the shorter-term sector.
The Fed then is left with a couple options — either raise the Soma limits currently blocking them from buying more than 35 per cent of any UST issue, or scale down their purchases. In the meantime though, watch out for those market distortions.
From Blackwell and Grubert’s conclusion:
We have long been against another round of QE2 because we believe the possible costs far outweigh the benefits. In our view, the economic impact of another round of purchases is uncertain at best and 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%. 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.
A handy RBC chart of that evolving Fed UST ownership this way.