Wednesday, September 2, 2009

Fed purchase lockdown

Zero Hedge is at it again. Having brought the world’s attention — rightly or wrongly — to the growing clout of high frequency trading in equity markets, the anonymous blog started last month to turn readers’ attention to the Fed’s permanent open market operations focused on Treasury and agency securities.

The theory postulated by the anonymous collective loosely centres around two points: the fact that 1) the Fed’s direct purchases amount to direct monetisation of freshly issued Treasury securities and 2) that a degree of collusion is potentially going on between the Treasury, the Fed and primary dealers to ensure that any newly issued Treasuries bought by primary dealers are immediately bought back by the Fed at no loss to the purchasers.

This action, the blog claims, is what’s been propping up equity prices more than anything else (which of course was the whole idea).

The second point, more so than the first, however, has drawn criticism.

Across the Curve’s John Jansen, for example, commented back in August that while he himself had spotted the first pattern, he strongly disagreed there was any collusion going on. As he stated (our emphasis):

The Zero Hedge blog composed a very fine piece on the composition of the Open Market Desk purchases of Treasury coupon securities and the time frame relative to the recent auction that the purchase was made. I discovered this pattern early in the process on March 27 and then again on April 2 and posted about it each time. So I agree with ZH regarding the fact that the Federal Reserve has purchased large blocks of recently auctioned issues. I vigorously disagree with that blog’s implication,intimation or assertion that there is collusion between the primary dealers and the Federal Reserve in which the Federal Reserve backs stops the dealers and guarantees the primary dealers that purchases of auction bonds will not produce a loss.

Indeed.

Nevertheless, there is one issue the market should be wary of. As Zero Hedge noted on Tuesday, the Fed’s purchase timeline is quickly running short. Having originally committed to $300bn worth of Treasury purchases, the latest auction on September 1 brings the total sum purchased since March to $276.3bn. This leaves less then $25bn for future auctions. As to what that implies, Zero Hedge commented:

As Zero Hedge discussed before, this total will be used up in the next 2 weeks. What then? All of a sudden the invisible bid under equities is looking very, very precarious. And here is a graphic representation to either D-Day for equities or to QE 2.0

Here’s that chart:

Fed Agency purchases - Zero Hedge

Which seems to suggest that when the Fed QE drip-feed is shutdown come mid-September, no-one can really be sure of how markets will respond. This is all the more the case if you consider how closely correlated the US equity market ‘recovery’ has indeed been to Fed purchases:

DJIA - FT

So, the question is, will markets be able to cope on their own? Or will a lack of QE money-flow from September come to spook the markets?

The answer, we guess, depends to what degree non-QE generated sums have come to support asset classes too.

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