Fed unleashed QE3

Highlights:
- Fed unleashed QE3. Fed will buy 40 billion mortgages a month, with no specified end date, and will continue with Operation Twist as is. Forward guidance was extended to “mid 2015”. Inflation concerns were largely marginalized; the clear focus of the Fed is on improvement in employment.
- The reaction in risky assets was traditional QE: equities up 1.5%, gold up 2%, dollar index down 60bp.
- Fixed income reaction was much more mixed. Initially, FI sold of 10bp in 10y yields to a high of 1.825%. Despite the extension of the forward guidance, 2015 Libor forward rates jumped by 14bp. The back end of the yield curve initially flattened. But all this was quickly reversed, and by the end of the day 10y yields are nearly all the way back to pre-FOMC levels, as are the 2015 Libor forwards. 10/30s reversed substantially and goes out over 4bp steeper on the day, back at its highest level since May.
- Bernanke did have the desired impact on mortgages. MBS-UST spreads compressed massively, by over 15bp. Current coupon mortgage yields, the “at the money” secondary market mortgage bond yields, tumbled over 23bp to its lowest ever level, 2.13%. By some measures, the MBS basis is at its tightest level ever.
- 5y5y breakeven inflation gapped higher on the decision. At one point breakevens were 10bp higher with nominal yields unchanged, and at their highest level since Aug of 2011 (when the market was building operation twist expectations ahead of Jackson Hole).
- The swap spread curve flattened massively after the FOMC decision. 5/10s spread switch quickly flattened by 2bp, as the lack of additional UST buying cheapened up USTs versus everything else, and particularly in the long end, where this is little clarity about Fed sponsorship after OT ends.
- Swap spreads tightened to the lowest levels in months. As the front end screamed (reds are up 5bp, now pricing in Libor in Mar 2014 effectively flat to today), 2y spreads compressed to 13.5bp. 5y and 7y spreads held their ground, tightening only marginally if at all, as that sector is clearly the favorite part of the curve to buy given today’s news. 10y and 30y spreads collapsed, with 10y spreads getting to 6.5, its lowest level since March, and 2.5bp tighter on the day. 30y spreads did not tighten as much, as the 30y sector was a favorite whipping boy in both cash and swaps.
- Tenor basis continued to collapse. Today it was 6s3s turn. 5y 6s3s has fallen nearly 2bp in 2-3 days, mostly today. As 6mL has remained sticky while 3mL has rapidly declined, the spot basis has widened sharply of late. The market is now beginning to price a rapid decline in that basis, and thus a rapid decline in 6mL.

Comment:
The highlights above summarize the nature of the day. The Fed definitely pulled out the stops and proved that its recent signaling (minutes, Jackson Hole, media) was not all smoke and mirrors. Ben Bernanke decided to tackle the stagnant job market head on, particularly by targeting market expectations about the duration of low rates and more importantly, mortgage rates. At least on Day 1, he has succeeded, pushing secondary market mortgage rates to their lowest ever yields, with the clear expectation that this should spill over to the primary mortgage rate as well. By choosing to target mortgages specifically, the Fed is doing its best to bypass the stagnant credit channel, and reach consumers as directly as possible. While many in the market felt QE was “priced in” the reaction in various asset classes shows that it clearly was not entirely priced in. Most notably, many mortgage market practitioners were proclaiming that QE was 90-98% priced in, yet this market reacted more violently than any other to the news. The reaction was initially read as a disappointment, as UST yields quickly sold off 10-15bp as some initially regarded the 40 billion per month rate as “not enough.” The 200 day moving average, which in the middle of August served as the braking point for the selloff, once again served that role. Treasury yields came all the way back and actually go out lower on the day 10y years and shorter, with the 5-7y sector being the best performer. In his Q&A, Bernanke was repeated asked to clarify the conditionality that would signal an end to the new round of bond buying, but repeatedly insisted that there is no specific number, and that the Fed will be looking for signs that the economy is strong enough to sustain labor market improvement. Essentially, he suggested that the Fed is keeping the labor market on life support, but does not have the ability to nor does it intend to nurse the market back to health (ie they won’t keep buying until the economy reaches full employment).

The question now is whether this initial reaction will persist, or begin to quickly fade away as it did after QE1, QE2 and Operation Twist. Given the new guidance, the search for yield will continue to move further out the curve, and we will likely see the 7y sector remain rich. Further, buy buying mortgages the Fed will be taking out duration from the market that resides in the “sweet spot” of the curve, with regards to carry and rolldown, and this will push investors further out the risk curve. This will be supportive of narrower swap spreads, which we saw today. Position wise, we will keep things pretty neutral for now, until the market shows a trend. Carry trades may be the best performer for the near term. In spreads, we are neutral now.