It is too early to say whether the Fed's second quantitative easing program will succeed, but it's already clear that the new program is distorting the Treasury market.
Volume and price patterns have shifted in ways that show how much daily activity is centered around the Federal Reserve's quick foray into the market on an almost daily basis.
Traders say volume now peaks before noon in New York, and prices have begun to display a regular downtick after 11 a.m., when the Fed completes its near-daily purchases of between roughly $7 billion and $9 billion in Treasurys.
The trend reflects bond dealers' efforts to guess which Treasury securities the Fed will choose to purchase each day.
Disappointment causes prices to fall as primary dealers — who help carry out quantitative easing by engaging in essentially a reverse auction with the Federal Reserve Bank of New York — try to offload into the market what they did not manage to sell to the Fed.
"A lot of dealers are going into the (Fed auctions) trying to get rid of what's on their books going into the end of the year," said Joseph Leary, interest-rate strategist at Citigroup in New York. "However, the downtick (in price) seems to indicate not everyone has the chance."
The Fed announced on Nov. 3 a $600 billion program to buy Treasurys in an attempt to stimulate the economy.
A week later, officials offered a detailed buying schedule, including a list of Treasury issues the central bank could potentially purchase — a list detailed enough to include the identifying numbers, known as CUSIP numbers, attached to each individual Treasury security.
That gave the primary dealers, the 18 banks and investment firms authorized to deal directly with the central bank, an idea of what the Fed wanted to buy. They now regularly offer securities for sale to the Fed, according to the list. Based on the prices and securities the dealers offer, Fed officials decide on what to buy.
Having the list of CUSIP numbers the Fed could buy narrows the field for dealers, but it doesn't completely remove the element of chance or competition from the Fed purchases.
The Fed still has room to choose between securities on any given buying day, and the central bank seems sometimes to choose the securities offered at the cheapest price. At other times, the price concern is secondary to the securities' maturity lengths.
"What the Fed is buying, their main target is—although they do buy the cheap issues and use a particular spine — their main target is probably a duration target," Leary said.
A "spine" is a chart of Treasury yields smoothed out into a single, curving line against which the prices of individual Treasury securities are plotted. Their proximity to the smoothed-out line lets traders determine whether they are "cheap" — a good buy — or "rich" — relatively expensive.
"The market's trying to be like OK, this looks cheap, there's a higher chance the Fed is going to buy this — but it's inconsistent," said Suvrat Prakash, interest-rate strategist at BNP Paribas in New York.
An analysis by Nomura Securities this week found that market volume has begun to concentrate around the Fed's appearance.
Analysts said over time the Fed buying could have an effect closer to its intended goal: lowering yields.
But first, year-end efforts to lock in profit must be completed, and the political controversy the program ignited must fade.
The Fed's new program has drawn criticism from foreign governments, including Germany and China, as well as from U.S. politicians. That prompted some market participants to fear that the Fed might have to cut short its purchases.
"When inflation stays low or goes lower, the market slowly comes to terms with what the economic backdrop truly is and the Fed maybe gains a bit of credibility," Prakash said.
He added that market participants might also be less skittish about the prospect that the Fed would have to end the program early once the political firestorm died down.
"Even though the market should be perfectly efficient, sometimes they need to see the situation on the ground before they can feel comfortable going ahead," he said.
Leary said the purchases were already flattening the yield curve and reducing the blown-out disparities in the values of different maturities along the curve. In time, he said Fed buying could give more support to the prices of Treasury Inflation-Protected Securities, known as TIPs.
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