About the Fed's Purchases of Treasuries

The Head of the NY Fed's Open-Market Trading Desk, Brian Sack, gave a
thoughtful speech yesterday at the CFA Annual Conference, where he
discussed the Fed's decision on August 10th to reinvest the principal
payments of maturing agency and MBS debt. He also discussed at some
length the various issues associated with the prospect of any further
expansion of the Fed's balance sheet. The full text of his talk can be
found at

http://www.newyorkfed.org/newsevents/speeches/2010/sac101004.html

It is worth keeping in mind that the Fed is already committed (before
they consider any additional such measures in the coming weeks) to
purchasing a very sizable amount of Treasuries over the medium-term, as
a result of the August 10th decision. At the time, they estimated that
the amount of agency and MBS debt that would be running off by the end
of 2011 was likely to be around $400 billion. In his speech yesterday,
Brian Sack stated that this estimate now is already"somewhat higher"
compared to what was considered on August 10th. This is the direct
result of the strong rally in the Treasury market in the interim, with
10-year yields declining by approximately 35 basis points since August
9th. (The Treasury rally and the ongoing tightness of mortgage spreads
increases the pace of MBS prepayments in the Fed's portfolio).

If long-term Treasury yields were to decline moderately further in the
near future, the Fed's "automatic" purchases of Treasuries would
increase even more. Of course, the exact additional amount of Treasuries
that would need to be purchased over the next 15 months (over that
initial $400 billion the FOMC mentioned on August 10) would also be
partly contingent upon the length of period that rates remain close to
their lows over that time frame. However, with the economic recovery now
expected to remain on a very moderate growth path, yields are likely to
remain low well into 2011.

All in all, the Fed may already be on track to purchase $500 to $600 billion of
Treasuries by the end of next year, WITHOUT explicitly announcing any additional
QE next month. Now, if the Fed does announce a stand-alone, "active" program of
additional Treasury purchases in November- and that adds significant
further momentum to the Treasury rally, then the combined effect of the
two programs of such purchases will be magnified due to an even faster
prepayment rate of mortgages as yields continue to decline. The end
result here is that the Fed may end up buying an appreciably higher
amount of Treasuries over the next 12 to 15 months than officially
stated; depending on the trajectory of economic activity over that
horizon, such a number could easily exceed the $1.5 trillion mark.

Anthony Karydakis