Anatomy of a pullback

The market wanted more

As we all know the Fed has been conducting open market open market operations to buy Treasuries. The plan is to buy $300 Billion of Treasuries by June of 2009 (six months from start to finish). So far the Fed has purchased just under $60 billion. The Feds moves are basic market manipulation. They have a desire to keep interest rates low to facilitate low cost borrowing which will in theory stimulate general economic activity. Low rates are also an essential component of the plan to allow borrowers to refinance their mortgages. So you buy Treasuries to push rates down long enough to accomplish these goals.

With an 800 pound gorilla like the Fed in the market I begin to wonder how their activity will impact the market. When I began looking at this issue I thought that the first thing I’d find was evidence of rising Treasury prices on days when the Fed was conducting open market operations. It would be very useful obviously if we could isolate the effect of their buying to see how much of a price impact they have when they wade into the market. Additionally we’d like to see if we could isolate any price pullbacks in the absence of Open Market Operations holding all else equal.

Today we saw something a bit unexpected. The Fed conducted open market operations today to buy Treasury bonds with 7 to 10 year maturities. The Fed purchased $7 billion worth of the $26 billion in Treasury bonds offered up by the primary dealers. Treasury prices rose this morning until around 9:30 Eastern. The market was expecting a robust buying session out of the Feds operations today.

The Fed released their statement detailing the mornings activity at 10:30 eastern time. This report showed less buying than the market anticipated. The pullback in Treasury prices began immediately after the release of the statement. In the graph below you’ll see the speed with which the market reacted to the Feds statement. From pre-announcement to the market close we’re looking at almost a 1-point swing.

The Fed’s Open Market Operations will continue to have a big impact on the markets. Today’s activity shows that the impact isn’t always as predictable as one might expect.

Food for thought

We know that the Fed wants to keep rates low…and they have some ammo with which to keep them low IF nothing out of the ordinary happens. However, the Fed doesn’t have pockets deep enough to fight the market and if inflation begins to heat up the Fed won’t be able to buy enough Treasuries to keep the long end anchored. This could cause a dramatic steepening of the curve. Another factor that could cause Treasury rates to rise is a reversal of the flight to quality that has helped drive rates to these historic lows. If the market perceives that the macro-economic picture is getting better you’d expect to see money move out of the Treasury market and into other sectors, whether it be into corporate bonds to take advantage of tremendous spreads or back into equities.

That’s all I’ve got. It’s late in the day, it’s nice out, the Mexican joint across the street has a patio in the sun and $3 beers…and I bet your town has something just like it. Go stimulate the local economy.

If you have any questions or if there is anything I can be doing for you just let me know.