Breathing room for the Federal Reserve

Filed on September 20, 2010

W atch WHAT they say, not what they do. Turning around the admonition of Richard Nixon’s attorney general John Mitchell may be the way to size up the Federal Open Market Committee meeting on Tuesday.

At the Fed policy-setting panel’s previous confab on August 10, the central bank decided to purchase Treasury securities to replace maturing agency mortgage-backed securities in its portfolios. That didn’t constitute a shift in monetary policy but a means to prevent a tightening caused by a shrinkage of mortgage holdings resulting from prepayments by homeowners refinancing at record-low interest rates.

Previously, however, the Fed’s discussions had been mainly on the unwinding of its audacious, $1 trillion-plus securities-purchase program announced in March 2009. Letting mortgage securities run off would allow part of that to be accomplished passively, without the outright sales of securities that would attract far more attention.

But Fed Chairman Ben Bernanke emphasised in his speech at the Fed’s big bash in Jackson Hole, Wyo., for policy-makers and academics late last month that, while the central bank doesn’t expect a double-dip recession, it would do what it takes to prevent one if it seemed to be a threat.

Since then, the skein of much-worse-than-expected economic data has given way to merely blah numbers. Moreover, the stock market has had a bounce in the past few weeks, confounding all the articles warning about September being the cruelest month for equities. Treasuries, which had soared in price amid the flight to quality, ran into a correction as fears subsided. All of which gives the FOMC some breathing room Tuesday. No further expansion of its purchase program for Treasuries is likely, and certainly nothing that would qualify as “QE2” — the second phase of quantitative easing, the popular abbreviation for the Fed’s balance-sheet expansion. Another has crept into the jargon — LSAP, for large-scale asset purchases.

Most likely, the FOMC won’t announce a new QE, LSAP or whatever BS you want to call it, but it could discuss steps that the Fed could take, and under what conditions. JPMorgan Chase economist Michael Feroli writes that there is a “non-trivial” chance the FOMC could announce a “medium-sized” buy of $200 billion-$300 billion. Odds favour no action at this time because of issues of “coalition building” on the committee, he adds. Published reports after the August FOMC meeting indicated that a significant seven of the 17 Fed governors and district presidents had expressed reservations about the plan to buy Treasuries to replace maturing mortgage securities. (The actual vote was 9-1 but some non-voting Fed presidents reportedly weren’t on board with the plan.)

The calendar provides a handy out for the FOMC. The committee’s next scheduled meeting will be a two-day affair on November 2-3. So, any decision could be deferred until the day after Election Day, letting the Fed lay low during this increasingly intense midterm campaign.

As RBC Capital Markets previously argued in this space, the central bank to watch in terms of buying of Treasuries isn’t the Fed but the Bank of Japan. Its surprise intervention to push down the yen from its 15-year high totaled an estimated ¥2 trillion ($23 billion). Unlike previous foreign-exchange interventions, the BOJ’s hasn’t sterilized the operation with offsetting sales of bonds. Typically, central banks invest the dollars they acquire in forex operations in the Treasury market, though RBC economist Michael Cloherty points out they can deposit the funds with the Fed (through reverse-repurchase agreements) or with banks.

For the week, Treasury yields fell on the short end on renewed concerns about the European sovereign debt situation, with Ireland rumored to be on the verge of requesting EU and IMF aid.

The two-year note yield slid to 0.472 per cent from 0.555 per cent, while the benchmark 10-year note dipped to 2.743 per cent, from 2.799 per cent. The 30-year bond yield edged up to 3.905 per cent, from 3.868 per cent.

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