Is The Market About To “Undo” The Federal Reserve’s Purchases?

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James Bianco has run Bianco Research out of Chicago since November 1990. He has been producing fixed income commentaries with a circulation of hundreds of portfolio managers and traders. Jim’s commentaries have a special emphasis on: money flow characteristics of primary dealers, mutual funds, hedge funds, futures traders, banks, and institutional investors.

Prior to founding Bianco Research, Jim spent time in New York as Market Strategist for UBS Securities, and Equity Technical Analyst at First Boston and Shearson Lehman Brothers. He is a Chartered Market Technician (CMT) and a member of the Market Technicians Association (MTA).

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Is The Market About To “Undo” The Federal Reserve’s Purchases?

  • Bloomberg.com – Vanguard to Use Floating Benchmarks
    Some index funds to use Barclays Capital float-adjusted bond indexes
    Several of Vanguard’s index funds will be switching to Barclays Capital’s float-adjusted bond indexes from the Barclays indexes that currently serve as the funds’ target benchmarks. According to Vanguard, the new benchmarks better represent actual liquidity in the marketplace and should help insulate Vanguard’s bond index funds from securities whose prices may be distorted by significant reduction in supply as a result of Federal Reserve buybacks.  The term “float” refers to the amount of a given security available for public trading; it excludes amounts such as those held by company insiders, affiliates, or governments. “We believe that float-adjusted indexes more accurately represent an investor’s opportunities in a particular market,” said Gus Sauter, Vanguard’s chief investment officer, in a release announcing the shift. “Whenever possible, Vanguard’s index funds will seek to track benchmarks that follow this best practice.”
  • Dow Jones – Vanguard Shifts Bond Index Due To Fed Buys
    The Vanguard Group plans to switch 12 of its bond index funds to benchmarks designed to exclude the hefty chunk of bonds the government has purchased through its buyback program. Other fund providers may follow suit. Eight existing and four proposed Vanguard bond index mutual funds and exchange-traded funds will switch to tracking the Barclays Capital U.S. Aggregate Float Adjusted Index and its sub-indexes by year’s end. Unlike the indexes now in use, the new indexes adjust for so-called float, or the number of shares currently available for trading, a practice more commonly associated with stock benchmarks that seek to disregard shares owned by governments, company insiders or corporations, which have no intention of selling. Vanguard says the new bond benchmarks more closely represent actual liquidity in the market, and thus should help insulate the funds from price distortions created by the Fed’s buybacks. The money manager says it expects no significant change in the risk attributes, including duration, of the bond index funds.Barclays – (July 30) Barclays Capital Announces the Creation of the US Aggregate Float Adjusted Index

    • A New Benchmark of the Dollar-Denominated Investment Grade Bond Market
      Barclays Capital, the investment banking division of Barclays Bank PLC and publisher of leading broad market bond benchmarks, today announced the launch of the US Aggregate Float Adjusted Index, a new benchmark of the dollar denominated investment grade bond market that excludes Treasuries, agencies and MBS held in Federal Reserve accounts. The new index will be published alongside the firm’s other leading indices, including the Global Aggregate, US Aggregate, Pan European Aggregate and Asian Pacific Aggregate. With an inception date of July 1, 2009, the new benchmark will offer investors a rules-based market value weighted index as a complementary alternative to the flagship US Aggregate Index, which includes agencies and MBS held in government accounts. The underlying constituents of the US Aggregate Float Adjusted Index will be the same as those of the US Aggregate Index, but net purchases and sales by the Federal Reserve will be excluded from the float adjusted index on a monthly basis, thereby reducing the market value weight of these securities. Sub-indices of the new index will also be available, including a US MBS Float Adjusted Index created specifically for mortgage investors.
  • Comment

    We discussed this back in May and June and said:

    The indexers are correct in including the MBS bought by the Federal Reserve as part of the float if they assume these securities will be sold back into the market once the economy improves. For now, this seems to be a likely scenario once the Federal Reserve wants to unwind its balance sheet.  See the story above as it sure implies the Federal Reserve is going to eventually see these purchases back into the marketplace.

    If, however, the Federal Reserve changes its mind and decides to hold these securities to maturity, then the float has been permanently reduced and the indexers have their weightings wrong.

    Apparently bond managers are now concluding the Federal Reserve is not going to sell their holdings acquired through their QE operations.  So, they are demanding the calculation of, and in the case of Vanguard, the adopting of  “float-adjusted” indices as their benchmarks.

    If this is the beginning of a trend, it has the potential to be a big deal. As the Federal Reserve buys, weightings in the float-adjusted indices fall (see the first table below).  Managers seeking to keep their weightings constant will then sell the same securities the Federal Reserve purchases.  Effectively this “undoes” the Federal Reserve purchases and defeats the purpose of the program.  In the end, it merely changes the ownership of securities and does little to push yields lower.

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