Stop Front-Running the Fed

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A change of mindset is in order for bond investors, who must recognize that it is no longer wise to “front-run” monetary policy by purchasing the same bonds the Federal Reserve is targeting with its latest round of quantitative easing (QE2).

During the so-called “QE1,” completed in March of this year, front-running the Fed’s bond-buying intention was a profitable pursuit, but, as I’ll explain, it is not this time around.

Policy makers at the Treasury Department and at the Fed may have painted themselves into a corner, making their respective policy objectives mutually dependent for the foreseeable future.  Specifically, the Treasury Department needs to extend its liability structure without breaking the federal budget, which it must do by selling longer-term bonds at today’s ultra-low interest rates.  At the same time, recent monetary policy at the Fed creates disincentives for investors to buy longer-term bonds at today’s interest rates, requiring the Fed to provide an alternative source of demand for these securities. 

Since the FOMC statement regarding its latest asset purchase program makes clear that the Fed intends to accumulate longer-term U.S. Treasury securities in the coming months, it is reasonable to assume that QE2 includes a hidden agenda, whereby the Fed serves as a buyer of last resort for U.S. government bonds that might not catch a bid from private market investors, at least not at prices the Treasury Department can afford to accept. 

If that’s the case – and I believe it is – the Fed is looking to keep long-term bond prices artificially high, for reasons I’ll explain in more detail. Bond investors may be wise to let the Fed take the lead with QE2, waiting for higher yields before following the Fed’s example.

Front-running then and now

The Federal Reserve surprised no one when it announced plans for a second round of quantitative easing on November 3rd. Its intent to launch another asset purchase program had already been telegraphed by various Fed governors, beginning with a speech by Ben Bernanke, the Fed chairman, on August 27th at a speech in Jackson Hole, Wyoming.