Fed QE Runs Risk of Mistiming and Backfiring!

by Chadd Bennett at Index Universe:

In order to get a sustainable recovery, the private markets, riding the momentum of the government’s stimulative measures in 2009, were supposed to be taking over right about now.
Instead, the opposite is happening, even as the Fed has decided to continue to pump money into the system. This represents, in my opinion, an admission that the window for the handoff to the private markets was missed, and now could be years away. That’s mostly because given the current state of the economy, it will be very difficult to duplicate the kind of economic and market momentum established after the government’s initial efforts to revive the economy after the financial meltdown of 2008.

If you agree with this notion that the Fed’s stimulative efforts failed to give the economy the escape velocity it needed to make the recovery self-sustaining, and furthermore, believe the Fed itself realizes that it missed this chance, then it should be safe to assume that there’s no turning back for the Fed. The confirmation came on Friday when Ben Bernanke said the Fed will be there for support in the face of any signs of deflation.
What’s important about this development is that this has caused the Fed to become the marginal buyer of U.S. Treasurys in a big way. Just as the government bailed out Fannie Mae and Freddie Mac, it’s now fast becoming the largest source of government funding.
This has placed the Fed in a difficult position of making current and future policy decisions more akin to a long-term portfolio manager rather than a central bank. As if it didn’t have a big enough challenge already, it’s now directly influenced by the moves it makes with current and future bond holdings rather than just the changes in interest rates it controls.
I believe this explains in large part why investors are more comfortable buying bonds at these levels. If you have a constant bid from a long-only market participant with unlimited buying power, what’s the risk?
The past few weeks have seen a surge in demand for fixed-income assets that rivals the run seen in equities during the tech boom. Bloomberg reported last week that “investors poured $480.2 billion into mutual funds that focus on debt in the two years ending June, compared with the $496.9 billion received by equity funds from 1999 to 2000.” It cited data compiled by it and the mutual fund industry’s Washington-based trade group, the Investment Company Institute.
Another relatively new and strong bidder for Treasurys, especially over the past year, is the U.K. or Bank of England. Looking at the Federal Reserve custody account shows U.K. Treasury holdings have more than tripled to over $350 billion over the past 12 months. 



While foreign demand in general, at least for Treasurys, has been steady, according to the Fed’s custody account, watching how these flows evolve is important when considering the sustainability of recent fixed-income price movements.



It’s hard to imagine, for example, that the accumulation of Treasurys by the U.K. and mutual funds will continue at the same exponential rate for much longer. Could U.K. holdings of Treasurys again triple, let alone rise another $230 billion, as they did in the past year? Not likely, in my view.
Also, it’s nearly impossible to measure the real implications of the Fed becoming the biggest holder and future financer of U.S. government. It’s this uncertainty that I think is and will be underestimated by the market. Part of this reasoning is that the harder and longer the Fed pushes with measures like quantitative easing, the fatter the hyperflationary tail becomes.
If and when this probability grows to a point where the market cares, it could cause a sudden shift in rates to the upside that would catch many off guard.
So, whether you agree or disagree with where bonds are priced right now, it’s tough to argue that the trade isn’t crowded at least in the near term. The potential reversal we saw in equities and yields last Friday is a possible sign that things need to revert to the mean a bit before they continue on their paths.