Jeffries on the FOMC minutes....quite good

From: DAVID ZERVOS (JEFFERIES & CO., INC)
At:  9/01  9:20:13

This is the key passage from the minutes on the thought process driving the reinvestment strategy decision – “members generally saw both employment and inflation as likely to fall short of levels consistent with the dual mandate for longer than had been anticipated. Against this backdrop, the Committee discussed the implications for financial conditions and the economic outlook of continuing its policy of not reinvesting principal repayments received on MBS or maturing agency debt. The decline in mortgage rates since spring was generating increased mortgage refinancing activity that would accelerate repayments of principal on MBS held in the SOMA. Private investors would have to hold more longer-term securities as the Federal Reserve's holdings ran off, making longer-term interest rates somewhat higher than they would be otherwise. Most members thought that the resulting tightening of financial conditions would be inappropriate, given the economic outlook. However, members noted that the magnitude of the tightening was uncertain”.

So the idea was that an estimated 20b/month in mortgage paydowns (which I would say is very much on the high side) was about to wreck the long of the bond market (excuse me???). Immediate action was apparantly necessary to stem this “massive” flow which equates in duration terms to about half of a monthly 5 year note auction!!! This was needed even though a few members correctly - “worried that reinvesting principal from agency debt and MBS in Treasury securities could send an inappropriate signal to investors about the Committee's readiness to resume large-scale asset purchases” (ya think??). The decision for the committee was to stem this HUGE leak in the balance sheet and not wait another month to look at the data and better prepare the market for more material changes if they were needed. I stand by my earlier assessment that this was one of the top 10 worst communication decisions in FOMC history. It just makes no sense to confuse a fragile market over something so small and meaningless from a policy perspective. The probability of sending the wrong signal was way too high, as only a few of the clued in Committee members acknowledged.

So let’s look at what this signally move actually accomplished. Did the FOMC “ease” financial conditions as they had seemingly hoped to do?? NO, they tightened them. Equities are lower, credit spreads are wider and the dollar is stronger since August 10th – NICE JOB. Further, and more importantly, break-even inflation expectations have fallen 30bps and REAL short term rates (4/13 Tips) are 20bps HIGHER in yield, while longer term real rates are flat. The FOMC managed to raise the real short rate with this "easing" move - it is mindblowing how bad this decision really was! The probability of sending the wrong signal with this decision was not just high it was 1!

I will requote my favorite line ever from a Ben Bernanke speech in 2003 – “when nominal interest rates are at or near zero, the central bank can lower the real rate of interest only by creating expectations of inflation on the part of the public”. Ben alluded to this in his speech last Friday so I remain hopeful that we will see something from the FOMC in coming months on a plan for potential easing action that does not involve buying loads of long term US Treasuries. Hopefully the Committee is looking at what they did to real rates and inflation expectations after this meeting as a signal back to them that this was a horrific communication decision. From my perspective, the only truly effective easing strategies from the Fed going forward involve the funding and/or purchasing of riskier assets. Fed buying of government bonds outright (or promising to buy them in the event the economy slows further) will only fuel a bond bubble that feeds off of rapidly increasing deflation expectations. This is the Japanese path!

Finally, turning to one of my other favorite topics, Im doing a little work on breaking down the effective mortgage rate outstanding by product type (conforming fixed, conforming adjustable, prime, alt a, subprime etc etc). Tomorrow I should have some really interesting numbers for everyone to chew on. Also, I have been reading research from a lot of other dealers that suggests only congress can generate a government induced refi wave. I will discuss tomorrow why that logic is flawed. Good luck trading.