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Wednesday, 19 September 2012

QE, Mortgaged Back Securities and Treasuries

Note that they are buying MBS, not treasuries (other than a bit of the long-dated via Twist); if they buy many more treasuries, the Fed will own such a large number of them that large parts of the treasury market will have no international liquidity left and will stop functioning properly. 

Now given that in addition to that being a disaster on its own, at a basic level treasuries are the foundation of the financial system. Huge numbers of transactions involve treasuries as collateral. No treasury equates to no collateral; similarly, treasury illiquidity equates to weak collateral. They know this fact, hence the announcement of open ended but no finite dollar amount pledged in. This is actually very different than if they had announced a $800bn QE3, locking themselves into that amount. It is not quite possible that they can actually buy that many without imploding the market. They have a bit of leeway with MBS but there is also a finite market there. 

In other words, rather than seeing this as infinite QE, it can be regarded as indeed the announcement that they are going all in and throwing in the kitchen sink, yet basically they are trying to keep people from realising they actually do not have a kitchen sink. It is more of psychology/jaw-boning than anything,

They could not deal with the consequences of saying they would not do it anymore. This is the real QE3: "We are telling people we are doing this to infinity in the hopes that people believe it and act accordingly and thus the problem goes away, and we thus do not actually have to do this to infinity, before people figure out that we actually cannot do this to infinity in the first place."

*QE3 is about using MBS (a much more finite market than Treasuries) to inject liquidity, and QE3 is not about using Treasuries to inject liquidity. There is no kitchen sink to throw. 
*For financial markets and effects to economies, LDMR negative returns will set in (refer to previous write-up: http://donovan-ang.blogspot.sg/2012/09/spx-correlation-with-qe1-qe2-ot-and-qe3.html).

Law of Diminishing Marginal Returns: 
Negative Returns Are Going to Be Priced In

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