March 6, Why Is The Fed Tapering? Michael Purves Chief Global Strategist Head of Equity Derivatives Research (203)

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1 Michael Purves Chief Global Strategist Head of Equity Derivatives Research (203) March 6, 2014 Why Is The Fed Tapering? As Yellen has taken the helm of the Federal Reserve, she has re-articulated the path that tapering is on course. In effect, she has reaffirmed a base case of tapering at each FOMC till no more bonds will be acquired. While she has mentioned that there was no pre-set course for bond buying, we take her at face value that barring a massive downward shift to U.S. and/or global GDP (or macro risk framework), she will continue apace with reductions in bond buying. To our mind, the decision to taper is all about a preference for other tools of interest rate suppression (e.g. guidance), and not about a meaningful shift in policy, nor a different view of the economy s trajectory. So why is the Fed, including its most dovish members, inclined to end the QE? Poor risk/reward would be an obvious, but unhelpful answer. Our view is that one of the non-articulated, but primary reasons is that the Fed has simply become too dominant in Treasury auctions, crowding out natural buyers. The Fed has been the giant elephant in the room, particularly for 10 and 30 year Treasuries. In 2013, the Fed effectively purchased more than 60% of all 10 year Treasuries issued and nearly 90% of all 30 year Treasuries issued. The same dynamics are occurring in the mortgage market as well. Given the Treasury s financing requirements over the next several years (requirements which presumably accelerate if CBO estimates of budget deficits post FY2015 are accurate), we believe restoring Treasury market auctions to an old normal will be, and should be, a key goal of the Fed. Continued bond buying not only inflates the Fed s balance sheet to even further unprecedented levels (and in turn risking unmanageable inflation), it also reduces liquidity for what can be argued are the world s most important security the 10 year Treasury bond. Revived liquidity for longer dated Treasuries decreases systemic tail risks and volatility down the road. Managing systemic tail risks is indeed one of the roles of the Fed, especially so when the Fed was the entity which actually created this tail risk. The Transition of Buyers Drives Volatility. The ability of the Fed to navigate this exit gracefully will be a test for both the Fed and the markets. Filling the enormous gap in Treasury buying will likely not be a smooth transition, particularly if the GDP upward grind continues apace and inflation metrics start showing some upward momentum. Questions are raised. Won t natural investors want to get out before the Fed gets out? Will China continue to sell Treasuries, particularly if it needs cash to shore up holes in its shadow banking system? Will EM central banks be able to buy Treasuries if their currencies continue to weaken? Treasury volatility has been remarkably muted this year thus far, but we think it is likely to expand as the giant elephant buyer is replaced by some group of other buyers. The MOVE index, which measures Treasury volatility, is currently at ~60; this index has a life time average going back to 1988 of 101. But while Treasury volatility is poised to increase, we also think the Fed is especially sensitive to rate spikes and will seek to manage this volatility. This in turn should spur equity market volatility. All in all, a difficult, but essential task is unfolding.

2 The Fed-Treasury Link Last year, the Treasury issued roughly $100 bn/month (gross issuance) of notes and bonds with duration of five years or greater. Of this amount, the Fed purchased $45 bn/month for an implied participation rate of roughly 45%. But as you can see in Chart 1, the Fed s purchases have been heavily skewed towards 10 and 30 year Treasuries where the Fed is in effect purchasing nearly 90% of 30 year Treasuries, and over 60% of 10 Year Treasuries. Chart Treasury Fed Implied Issuance Acquisition Fed. (Bn/Month) (Bn/Month) Particpation 5 Yr % 7 Yr % 10 Yr % 30 Yr % Total % Note: Ignores TIPS Prospective Participation Rate Requires Aggressive Taper. We can see in Chart 2 that the effective participation rates decline substantially with further bond purchase reductions (we make the simplifying assumption that 2013 Treasury issuance size and by maturity as well as Fed weightings of Treasury purchases are similar to 2013 weightings). However, even if the Fed reduces to $15 bn per month, the Fed still be purchasing for 22% of the 10 year market and 30% of the 30 year market a major stride forwards, but still the big elephant in the room. Chart 2. 2 Implied Fed Participation Rates at Various Bond Purchases Levels Treasury Fed Implied Implied Participation Rates Issuance Acquisition Fed. Pro Forma Fed Purchases Per Month (Bn/Month) (Bn/Month) Particpation $ 35 $ 30 $ 25 $ 20 $ 15 5 Yr % 23.7% 20.3% 16.9% 13.5% 10.2% 7 Yr % 19.9% 17.1% 14.2% 11.4% 8.5% 10 Yr % 51.1% 43.8% 36.5% 29.2% 21.9% 30 Yr % 70.1% 60.1% 50.1% 40.1% 30.0% Total % *Assumes consistent weightings across sectors and Treasury Issuance in Excludes TIPs. 1 Source: Department of Treasury, New York Federal Reserve. Ignores TIPS. 2 Pro Forma participation rates assume equivalent Treasury issuance and maturity weightings to 2013.

3 Participation Rate Highly Sensitive to Reduction in Supply Last year we saw a reduction in Treasury supply due to better than expected budget deficits. Participation rates for 10 and 30 year Treasuries are highly sensitive to decreases in supply, as we can see in Charts 3 and 4. The CBO has once again revised its budget deficits downwards for FY Chart Implied Participation Rate for 30 Year Bond Growth In Treasury Supply Relative to % -20.0% -10.0% 0.0% 10.0% 20.0% 30.0% Aggregate % 87.6% 77.9% 70.1% 63.7% 58.4% 53.9% QE/Month % 75.1% 66.8% 60.1% 54.6% 50.1% 46.2% % 62.6% 55.6% 50.1% 45.5% 41.7% 38.5% % 50.1% 44.5% 40.1% 36.4% 33.4% 30.8% % 37.5% 33.4% 30.0% 27.3% 25.0% 23.1% Implied Gross Issuance $ $ $ $ $ $ $ Increase/Decrease from 2013 Level (41.7) (33.4) (16.7) Year Avg. Historic 30 Year Issuance $ $ $ $ $ Note: Implied Participation assumes 30 Year Purchase Weightings Equal to 2013 weights (27.8% of total Treasury Purchases) Chart Implied Participation Rate for 10 Year Bond Growth In Treasury Supply Relative to % -20.0% -10.0% 0.0% 10.0% 20.0% 30.0% Aggregate % 63.9% 56.8% 51.1% 46.5% 42.6% 39.3% QE/Month % 54.8% 48.7% 43.8% 39.8% 36.5% 33.7% % 45.7% 40.6% 36.5% 33.2% 30.4% 28.1% % 36.5% 32.5% 29.2% 26.6% 24.3% 22.5% % 27.4% 24.3% 21.9% 19.9% 18.3% 16.9% Implied Gross Issuance $ $ $ $ $ $ $ Increase/Decrease from 2013 Level Year Avg. Historic 10 Year Issuance $ $ $ $ $ Note: Implied Participation assumes 10 Year Purchase Weightings Equal to 2013 weights (32.0% of total T Bond Purchases)

4 Fed Also Increasingly Dominant In Mortgages MBS issuance has been decreasing substantially over the last 12 months (Chart 5), which in turn has driven up Fed participation rates to nearly 50% (Chart 6). There are several reasons for declines in issuance, but the correlation with declining home sales and mortgage applications is obvious enough (Charts 7 and 8). Chart Monthly Agency Issuance Feb Apr Jun Aug Oct Dec 2013 Feb Apr Jun Aug Oct Dec 2014 Chart % 2013 Implied Fed MBS Participation 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 3 Source: SIFMA. 4 Source: SIFMA, Federal Reserve. Participation Rate based on $40 bn/month purchases.

5 1/1/2012 3/1/2012 5/1/2012 7/1/2012 9/1/ /1/2012 1/1/2013 3/1/2013 5/1/2013 7/1/2013 9/1/ /1/2013 Chart MBS Issuance (USD Bn$) Home Sales Growth Chart 8. 6 M B S I s s u a n c MBS Issuance (USD Bn$) Mortgage Applications e SIFMA, National Association of Realtors. 6 SIFMA, Mortgage Bankers Association

6 Looking to the Broader Term Over the next several years, the Treasury needs to embrace the following challenges: 1. Record high sovereign debt levels, which will need to be rolled over. 2. Increasing Deficits. Per the CBO, after the FY2015 low in deficits, a rapid rise in deficits through FY This resurgence is driven primarily by Social Security and Medicaid/Medicare unfunded liabilities. 3. A desire to extend debt average debt maturity. The average maturity is increasing and the Treasury has been public about its desire to continue to extend its average life. This is understandable given the record low interest rate environment (and record low credit sovereign credit quality). The key points here is that the Treasury (and, by extension, the Fed) needs to be able to provide a strong stable and liquid market for Treasuries to accommodate the significant issuance of longer dated Treasury notes and bonds. This process will likely lead to higher Treasury market volatility and, most likely, higher yields if GDP expectations come in as expected. Restoring liquidity to Treasuries will be an essential task here in the coming 24 months. Disclaimer: This publication is prepared by Weeden & Co. LP s ( Weeden ) trading department, not its research department, and is for informational purposes only. It is not intended to form the basis of any investment decision and should not be considered a recommendation by Weeden or its associates and/or affiliates. The material herein is based on data from sources considered to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. It is not to be construed as a representation by us or as on offer or the solicitation of an offer to sell or buy any security. Options involve risk and are not suitable for all investors. Trading in options is considered speculative and it is possible to lose all, a portion of, or funds in excess of your initial investment. Any calculations and valuations presented herein are intended as a basis for discussion. Any opinions or estimates given may change. Weeden undertakes no obligation to provide recipients with any additional information or any update to or correction of the information contained herein. No liability is accepted by Weeden for any loss that may arise from any use of the information contained herein or derived here from. From time to time, Weeden, its affiliates, and/or its individual officers and/or members of their families may have a position in the subject securities which may be consistent with or contrary to the recommendations contained herein; and may make purchases and/or sales of those securities in the open market or otherwise. This publication is intended solely for Weeden s institutional customers/brokerdealers. Use by other than the intended recipients is prohibited. This publication may not be reproduced or redistributed outside the recipient s organization.

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