What happened to that Exit?

Once again, proving that talk about a Fed Exit Strategy (also see follow-on article) in middle 2009 and early 2010 was nonsense and quite premature, the Fed finally announced Wednesday what it had been signaling for the prior several months ... a return to more asset purchases (balance sheet expansion). Neither the timing nor the amount was a surprise to any that were paying attention ... this time targeting an amount of $600 billion through June of next year. In fact, to ensure that the Fed would not spook the markets, it had recently solicited its primary dealers for projections of central bank asset purchases over the next six months. The anti-climactic announcement that afternoon resulted in an initial "buy the rumor, sell the news" reaction from traders (in both the Gold and equity markets), before retracing most if not all of the losses on the day. December Gold futures fell from an early morning peak of $1364.80 all the way to $1325.50, before finishing the Wednesday afternoon trading session near $1350. December Gold has yet to take out an important low of $1315.60 on the daily chart, which is providing some support for the time being. But this target is certainly still in play, despite yet more new record highs in the near term being more likely.

The new purchases will be comprised mostly of maturities in the 2.5 to 10-year range (86%). This revelation did catch some by surprise as the 30-year sold off on the news. Meanwhile, these new purchases will be in addition to the treasury purchase program currently in effect to replace maturing Agency Mortgage-Backed Securities (MBSs) on the Fed balance sheet (dubbed affectionately and incorrectly as "QE lite"). This program is expected to be approximately an additional $250 billion to $300 billion through June of next year. However, since these purchases continue to be equivalent in magnitude to the maturing MBSs in the Fed portfolio, the program is reserves and balance sheet neutral. In fact, it improves the composition of the Fed balance sheet as MBSs are effectively swapped for treasuries. Though, the MBSs that remain on the Fed balance sheet are likely of generally lesser quality. Why?

The near zero-interest rate policies of the Fed the past couple of years triggered an unexpected side effect ... especially in late 2009 and 2010 once the banks deemed it safe to peek out of their fox holes. It triggered a larger than expected Fed balance sheet contraction due to the substantial wave of consumer mortgage refinancing. The maturation of these mortgages resulted in these assets being removed from the balance sheet and the principal repayments disappearing into the ether (money is destroyed when the Fed sells assets or assets mature). Since the Fed balance sheet was shrinking, it decided to act and keep reserves neutral (see, the Fed really is not interested in an exit strategy any time soon) ... hence the smaller treasury purchase program mentioned above. As for the prior mentioned general quality of the remaining MBSs on the Fed balance sheet ... the higher quality mortgages will qualify for refinancing (and the incentive to refinance is strong in an artificially low long term interest rate environment) and the lower quality ones will not. Thus, in what was a vast pool of MBSs (~$1.25 trillion), higher quality mortgages are leaving the pool (about $200 billion thus far, with another $250 to $300 billion expected through June) ... and what remains is an increasing proportion of mortgages on the Fed balance sheet that do not qualify for refinancing.