IS THE FED OVERPAYING FOR BONDS?

One of the many myths which appears to persist around QE2 is the idea that the NY Fed is massively overpaying for bonds which would, in effect, amount to a fiscal operation.  The idea is simple.  If the NY Fed pays $200 for a 7 year bond that is currently worth $100 then they’re essentially “printing money”.   Is that really happening though?  Not according to the facts.

The nice thing about our increasingly transparent Fed is that they make all of this data available for us online.  So we can actually see these operations, what they paid and what the premium/discount was relative to market prices.  Unfortunately, we don’t get to see the data in real-time, but we do get to see what’s going on by reviewing recent transactions which gives us a very good idea of what they paid relative to current market prices.  For instance, on September 9th the NY Fed executed one of their permanent open market operations.  Interestingly, most of the bonds were bonds that had been auctioned off in the last year so it’s easy for one to conclude that they’re “monetizing” this debt.  Of course, the Fed can’t and doesn’t “fund” the US government so it’s nonsensical to say such things.

Anyhow, the data shows the average price and high price of the $3.345B operation on the 9th.  We can also see today’s current prices (September 21) for these bonds.  Now, the prices have obviously moved since the 9th (a week’s worth of trading) but the prices are not far from where the Fed paid.  In fact, the premiums are rather small (bear in mind this isn’t the exact price from the day of the operation):

Now, I haven’t gone back and done this for every day during QE2 so the data could vary on different days, but I think it’s clear that we can take the Fed seriously when they claim they are buying market prices or near market prices for these bonds.  More importantly, the net interest lost to the banks via the duration reduction is more than offsetting any potential fiscal injection that these bond purchases might be producing.  In 2010 that was in excess of $70B that went directly to the Fed which then goes to Treasury in a direct reduction of the Federal deficit.

Is the Fed overpaying for bonds?  Not according to the data.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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17 Comments

  1. effem says:
    09/21/2011 at 1:35 PM

    I doubt they would do something as stupid as blatantly overpay. However, it is hard to understand how the taxpayer comes out ahead when the Treasury pays a fee to issue debt and then the Fed pays a commission to buy it back.

    • Cullen Roche says:
      09/21/2011 at 1:40 PM

      Right. Well, I think the hope is that they’re able to create an economic effect that is SUBSTANTIALLY larger than the losses in the commissions to the banking sector. But since the policy is implemented all wrong they’re not creating any real economic effect aside from market distortions. So, we’re all losers in the end except for the banks shaving off their fees inbetween…..I really think the Fed has good intentions here. It’s just more monetary policy based on myth and misunderstanding….

    • Dismayed says:
      09/21/2011 at 3:19 PM

      Don’t criticize the fees and commissions that the Fed and the Treasury pay – that ‘fiscal stimulus’ is the only part of QE that is effective!

  2. Anonymous says:
    09/21/2011 at 2:43 PM

    isnt the claim that the Fed is overpaying for bonds based on the assumption that when they ultimately go to sell them that they will have to do so at a discount (when interest rates are higher)?

    im not sure that the purchase price is what matters here, but the expected sale price

    • Cullen Roche says:
      09/21/2011 at 3:08 PM

      They don’t need to sell….Since they’re paying IOER they can hold the portfolio forever. So there’s no reason to sell and even if they did it wouldn’t matter. The Fed can’t go bankrupt anyhow. I have a feeling the Fed’s B/S will be bloated for many years to come…..

      • Gerald P says:
        09/21/2011 at 7:22 PM

        As the bonds are sold for dollars and then bought back for near the same dollars, how is this “printing money’? Aren’t dollars all fungible dollars (they do change in purchasing power of course).

  3. Mark says:
    09/21/2011 at 3:14 PM

    The fed might not be paying more at the time of purchase, but the fact that the fed announced their bond buying intentions well ahead of time would make me think that the market factored this in such that the fed was paying a higher market price at the time of purchase versus when the purchases were announced.

    Also if in fact there was no money pumping at all into the system from QE then how do you explain the rising market during each QE operation?

    Great work on this and I love the site.

  4. kim says:
    09/21/2011 at 4:18 PM

    My understanding was (and I’m way out of date) that the primary dealers have to make two way prices to the Fed, at some fixed bid-offered spread (not sure if that’s a rule, or simply an “onus”).

    If so, I’d be wary of quoting a price out of line ! Fed could really whack me….

  5. James Kostohryz says:
    09/21/2011 at 7:02 PM

    Cullen:

    I totally agree that the Fed does not pay above market prices for bonds.

    However, I would like to draw your attention a somewhat different issue that I brought up in a series of articles today. In my view, whenever a central bank purchases government securities — particularly long term government securities — at substantially negative real rates of interest, an important and very risky line has been crossed. I know you may not agree, but I would be interested in your comments, nonetheless.

    On Seeking Alpha:

    Fed Primer: Could The U.S. Repeat Weimar’s Inflation Experience? Part 1
    on Wed, Sep 21 • IEF, TLT • 22 Comments
    Fed Primer: Could The U.S. Repeat Weimar’s Inflation Experience? Part 2
    on Wed, Sep 21 • TLT, IEF, GLD • 54 Comments
    5 Reasons The Fed Will Not Push 10Y Rates Below 2.0%
    on Wed, Sep 21 • IEF, TLT, GLD • 37 Comments

    James

    • Cullen Roche says:
      09/21/2011 at 7:44 PM

      Hi James,

      My research has led me to believe that hyperinflation is more than a monetary phenomenon. You might be interested in this piece. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1799102

      Cullen

      • James Kostohryz says:
        09/21/2011 at 8:00 PM

        Cullen:

        I just read your paper. I actually agree with you. I am not a fan of the quantity theory of money.

        However, as I detail in the series of articles cited, I believe that a common element in loss of confidence in a currency is purchase by the central bank of government bonds at negative real interest rates.

        James

  6. JWG says:
    09/21/2011 at 7:58 PM

    The beauty (and danger) of elastic and unlimited keystroke money is that it is impossible to “overpay” for anything, unless the dollar is rejected as a means of exchange and then it’s too late. The Fed could theoretically buy all European sovereign debt on offer tomorrow at par and bail out Europe. Counting metaphorical pennies on bond prices and commissions misses the big picture.

    The Fed is in the process of losing control of its balance sheet, if it hasn’t already. When it recently tried some orderly sales of MBS, that market tanked. It’s again pumping out billions on swap lines. All it can do now is hold to maturity and pray it isn’t faced with the choice between massive new LSAPs and a worldwide bank run starting in Europe. Massive new LSAPs might trigger a loss of confidence in the dollar; beware the madness of crowds. The price of gold is telling us something.

  7. Neil Wilson says:
    09/22/2011 at 3:10 AM

    “In 2010 that was in excess of $70B that went directly to the Fed which then goes to Treasury in a direct reduction of the Federal deficit.”

    Does that actually happen in the US?

    Here in the UK the money from the coupons sits in the Asset Purchase Fund Facility doing nothing, while our equivalent of the Treasury (the Debt Management Office – DMO) issues extra bonds to ‘pay’ for these coupons.

    The result is that the amount of excess bank reserves created by QE and held by the private banks is going down over time.

    The reason they are doing this is straightforward – it’s to offset the ‘pull to redemption’. They paid, say, $105 for the bonds and ‘borrowed’ from the central bank to do that. That means they need $5 of coupons and $100 of redemption funds so they make sure they clear the central bank loan.

    So the money doesn’t go back to DMO but is held to ensure that the central bank loan can be cleared.

    We’ve had an eighteen month pause in QE operations so the trend is pretty clear in the UK.

    I was wondering if you were seeing the same effect in the US?

  8. freemarketeer says:
    09/22/2011 at 10:41 AM

    They’re no overpaying in that they are paying the prevailing market price, but is the market price indicative of true value, or has it been run up in anticipation of Fed buying? In the equity market, such behavior is typical, but I don’t know much about the bond market.

    • Mark says:
      09/23/2011 at 1:13 AM

      I have the same question. I don’t see any reason why prices can’t be run up ahead of fed buying since they are clearly announced beforehand.

      • Cullen Roche says:
        09/23/2011 at 2:00 AM

        Because if you look at the price of the bonds you can see that they weren’t run-up in advance. The traders would have to move the entire offering which would create an arbitrage in the entire 7 year offering. That’s practically impossible to do. Besides, I am looking at the prices and you can see that the offering and sale price on 9/9 for instance on 912828Qg8 is accurate. Pretty hard to distort a trillion dollar market!