To spare any suspense, the answer is the New York Branch of the Federal Reserve. There has been a clear and obvious shift in the target for the POMO end of QE purchasing. This happened the week of November 20; that same date that I highlighted yesterday as important systemically. This adds to that picture.
Before getting too far ahead, I think it important to back up a bit. Since the beginning of the dollar tightening/credit selloff on May 2, the curve has largely steepened in the middle arena. In the second (or third, depending on how you view and define these things) leg of the selloff that began October 23, that steepening grew very intense and led to an obvious anomaly in the swaps market.
After November 20, the curve has dramatically and rapidly devolved backward, from steepening to flattening in that area. That has been marked by a growing divergence in behavior, obviously, between the 5-year and the 10-year. But more recently, particularly since the beginning of January, the 10-year has acquired seemingly a mind of its own. In this latest buying frenzy of the past week, where the yield on the 10-year has compressed a quarter of a percent, swaps rates did not follow much at all. Curiously, that has led to a decompressing and steepening swap spread at the 10-year maturity.
So we end up with a curve that has flattened in the all-important middle to benchmark section back to where it was at the September 5 rally point, at the same time the swaps market fails to confirm 10-year cash buying.
As I said in the outset, we don’t have to look far for a culprit. I have summarized certain transactions in the POMO operations at FRBNY, the Fed’s agent branch conducting QE, going back to September. The emphasis here is on purchase activity in treasury securities maturing in 2023 and 2024 – the 10-year range.
Apart from some buying in the week of October 2, the Fed had little interest in the 10-year range. It was largely buying up in the middle part of the curve and further down at the long end. Suddenly, the week of November 20, that all changed.
Just as the curve reached its steepest point, on the way to blowing out higher, with something dramatic occurring in the swaps market, the Fed totally re-oriented its POMO operations to highlight the 10-year range. Who is flattening the curve? The Fed.
The problem for analysis here is to discern which is cause and which is effect. Did the swaps anomaly cause the Fed to spring into action, or did the Fed’s sudden shift create a bad trade position(s) for a (some) dealer(s)? That is near impossible to tell.
My guess is more the latter. The steepening in the yield curve has had an effect on the mortgage market and I have to believe that caused more than a little consternation in the world of the FOMC and its models like ferbus. The blowout of the 10-year relative to everything else, particularly its impacts on mortgage rates, might have been more than enough to force a change in POMO behavior. The Fed has a vested interest in trying to manage the housing market and its last remaining transition channel, and it certainly recognized dire repercussions from losing control there.
If that change was not a full part of “forward guidance” or any other communications, at least to all market participants outside the Fed’s inner circle of connected bankers, then it stands to reason that somebody got taken out on a stretcher that week – positioned for further steepening just as the Fed comes in with its POMO-power would have been a bad place to be.
The other intriguing possibility, and this is not mutually exclusive with the above hypothesis, is that the Fed moved in to arrest the curve steepening not just as a nod to mortgage woes but to rescue one of those connected dealer banks. If there was a bank (or two) caught up in the curve changes after the dramatic bond selloff and dollar volatility, the Fed would certainly entertain suppressing any distress before it grew to proportions that might upset current estimates of “tail risks.” Remember, nearly every Wall Street bank reported horrible trading results (particularly in credit trading, and even more specifically in derivatives trading) in that quarter and there is every reason to believe that was still an ongoing issue. The behavior in these markets more than suggests that is the case.
In any event, there is the growing divergence between the Fed’s actions and the rest of the credit markets. As the swap spread shows, the swaps market is not “buying” the 10-year’s move, and neither is the rest of the credit complex, at least to such a degree. Such is the life of highly manipulated markets, as this highlights the competing and cooperating angles of market agents and the central bank interests. Paradigm shifts are always ugly and unpredictable, especially for central bankers trying to assert control and authority.
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