Front Running the Fed In the Treasury Market

I had a friend from the old neighborhood who was Comptroller of a major casino in Las Vegas in 1970-80s, where I also was married in 1981. Only lasting win from there, ever.

According to this dour son of Italy the way he could spot a problem, besides the more aggressive methods of observation and detection, would be to examine the returns on a table basis. In the short run they will vary, but in the longer term each game will provide a statistical return that rarely deviates from the forecast, unless someone is cheating. We would walk through the casino, and he would point to a table game and say "at the end of the month, this table will bring in xx percent."

It was he who introduced me to Bill Friedman's book, Casino Management, which is a useful read if you wish to learn more about that end of the speculative business from the house perspective.

Attached is some information from a reader. I cannot assess its validity, not being in the bond trading business. But it does sound like someone has tapped into the Fed's buying plans to monetize the public debt and is front running those buys, essentially 'stealing' money from the public. Its what they call 'a sure thing.'

To try and figure out who might be doing it, I would look for some big player who is showing extraordinary returns on their trading, with consistent profit that is not statistically 'normal,' too consistently good. The problem with cheaters is that they sometimes get greedy and call attention to themselves.

In Las Vegas the bigger cheats were often taken out into the desert for further inquiry and final disposition. On Wall Street they are somewhat more arrogant and persistent, defying resolution with that ultimate defiance, "We'll just find other ways to cheat again."

Time for a trip to the desert?

Here are a reader's observations from the bond market.

From a reader:

I used to work for a BB on a prop desk until the financial crisis took hold and they fired the less senior guys on the desk. I now trade US Treasuries, for a small prop firm in xxxxx, to scalp basis trades in mostly on the run securities. Occasionally, I will also take position in the repo markets for off the runs if I see something "mispriced." Your recent article piqued my interest because we too have noticed "shenanigans," of sort, in the QE program of USTs.

What we noticed, especially in smaller issues like the 7 Year Cash is that before a Fed buy back would be announced the price would pop significantly as buyers would run through all the offers on two major electronic exchanges (BGC Espeed and ICAP BrokerTec). This occurred more than several times as the 7 Year Cash would be overvalued both by its BNOC by 20-30 ticks and its relative value to similar off the runs. This buyer(s) would lift every offer they could, driving the price substantially above its "value" for sometimes a week at a time. After this buying would occur, the Fed would then announce the purchase of that security sometimes a handle above its approximate value. This "luck" did not just occur in the on the run 7 Year sector, it also occurred in the 30 Year Cash, 3 Year Cash, and more than several off the runs. Again, it was especially prevalent in the less liquid treasury products. Often the "appetite" for these securities would begin approximately 2 weeks to 1 week before the official Fed announcement. The buying was well organized and done in such a way as to completely knock it off kilter from its relationship with like cash Treasuries and the CME Ten Year Contract. If you examine the charts of some of the selected buy backs before the official announcement, you will see a similar occurrence.

While I have not broken this down into a paper to prove it (and I see nothing positive coming out of contacting the ESS-EEE-SEE about this issue), I can assure you that it was occurring on a consistent basis across the entire curve.

A certain issuance would be bid up through the market (substantially above value, as derived by several metrics) only to be later gobbled up by the Fed at the unreasonable price. These player(s) had substantial pockets as we, the small guys (but with a decent capital base), would take the other side of what seemed to be an obvious fade. While this did not occur in every single issuance of the QE program, it occurred often enough to be obvious to any learned observer.

While I am not sure if this can be attributed to purposeful Fed policy or someone at the Fed talking to his pals, I am certain it transpired."

Corruption is inevitable when the government is engaged in manipulating the markets with public monies. That portion of the Fed's activities needs to be scrutinized by the GAO on a continual basis. And the activities of the Exchange Stabilization Fund and the Treasury in market intervention should be subject to review by the legislative branch on behalf of the people.

Of course another option is to keep the Fed and the Treasury out of the public markets altogether excepting short term interest rates and specifically identified emergencies.

About Those MBS Purchases in Option Expiry Week

Several readers were kind enough to write in with more material about this correlation as noted in the ContraryInvestor as I had requested.

If the Fed is buying in the TBA portion of the MBS, it is clear that this is a cross-correlation, since both this market and option expiration have similar dates.

Friend Lee Adler over at the Wall Street Examiner has also been tracking this and notes:

"Jesse (whose work I greatly respect or I wouldn't feature it) is wrong on this count in my view, but correct in that the MBS purchases do have an impact on stocks, as does any liquidity pumping. But that impact is far less than the direct impact of open market operations directly with the Primary Dealers, as was the case in the direct Treasury purchases, and the GSE purchases. When the MBS liquidity is withdrawn it will have an impact, but mostly on the Treasury market. The impact on stocks will be secondary, and not pretty, I might add."

He specializes in this area, and his analysis seems to be 'spot on.' But I have to add to this that Jesse is not the Contrary Investor, although I would be glad to be the author of his databases and excellent analysis on the markets, on the whole, week in and week out. And I often rely on information and perspectives from a variety of connoisseurs of financial data, who add immeasurably to the daily fare here.

Here is what JESSE said.

"The data is intriguing to say the least. As you may recall, option expiration in the US stock indices occurs on the third Friday of every month. We have pointed out in the past that this monthly event is often the occasion of some not so subtle racketeering by the funds and prop trading desks of the banks in separating the option players from their positions, and pushing prices around to maximize the pain.

Why would the Fed wish to provide extra liquidity, to the tune of $60 billion or so, for the banks during that week? There must surely be other ways to support the equity markets. Such as buying the SP futures in the thinly traded overnight session. I am not aware of a strong correlation for stock selloffs or extraordinary weakness in option expiry weeks per se.

It might not be a coincidence, but there could be some unrelated event in the mortgage markets that also occurs on the third Friday or Thursday of each month. We are not aware of it, but that does not mean it does not exist. They might also be making the purchases more randomly, but reporting them on some schedule as the Fed does its H.41 reports, for example. Anyone who might know of such a cross correlation would be kind to let us know of it."

And here is my addendum from today.

Addendum 22 Jan: Several readers have written to suggest that the Fed is buying
in the TBA markets, new issues, and that they have fixed settlement dates that
roughly coincide with stock options expiration. That does not remove the
potential material effect of providing liquidity in options expiry week, but it
certainly does nullify the imputation of deliberation. I think the front running
as noted in the blog today in Treasuries is more obvious and plausible."

I was intrigued but skeptical of the meaning of this correlation, confessed my lack of specific knowledge, AND suggested an unrelated cross-correlation, with a request for input from readers. It was just too obvious and did not seem to have a point. Option expiry is a week of back and forth manipulation and not a substantial ramp. It also goes against my basic model that the Fed minds the bond market, and the Treasury, as head of the Working Group on Markets and the Exchange Stabilization Fund, keeps it eye on stocks via the SP futures. And a defendant will have gone to prison on weaker circumstantial evidence than that which supports the case for central bank manipulation in the precious metals markets.

"Jesse" is often on the edge in his inquiry, and asks a lot of questions, reads lots of material, but always seeks the data, and cuts it with a skeptical eye. That is the method of preparation in Le Cafe.

Related, here is some additional information on how MBS Analysts Watch the Fed's Every Trade.

I think the real question does remain, "What happens when the Fed stops buying?" and of course, "Is someone front running the Fed's purchase in the Treasury markets (and perhaps MBS for that matter)?"

Audit the Fed, and we will know much more.

Why Are 86% of the NY Fed's MBS Purchases Occurring During Option Expiration Weeks?

My friends at ContraryInvestor have published some remarkable data this evening in their twice weekly (subscription) analysis of the economy and the markets. This is one of the best analysis sites we follow, and highly recommend that you at least take advantage of their complimentary monthly newsletter.

This data suggests that the Fed's purchases of Market Backed Securities serves not only to artificially depress mortgage rates and the longer end of the yield curves. The purchases occur, with a remarkably high correlation of 86%, during monthly stock market options expiration weeks in the US.

"...since July, there has only been one options expiration week whereby the Fed did not buy at least $60 billion of MBS during the options expiration week itself, providing instant and meaningful liquidity during options expiration weeks that have historically had an upward bias anyway! Talk about timing of liquidity injections to get maximum effect in the equities market."

The data is intriguing to say the least. As you may recall, option expiration in the US stock indices occurs on the third Friday of every month. We have pointed out in the past that this monthly event is often the occasion of some not so subtle racketeering by the funds and prop trading desks of the banks in separating the option players from their positions, and pushing prices around to maximize the pain.

Why would the Fed wish to provide extra liquidity, to the tune of $60 billion or so, for the banks during that week? There must surely be other ways to support the equity markets. Such as buying the SP futures in the thinly traded overnight session. I am not aware of a strong correlation for stock selloffs or extraordinary weakness in option expiry weeks per se.

It might not be a coincidence, but there could be some unrelated event in the mortgage markets that also occurs on the third Friday or Thursday of each month. We are not aware of it, but that does not mean it does not exist. They might also be making the purchases more randomly, but reporting them on some schedule as the Fed does its H.41 reports, for example. Anyone who might know of such a cross correlation would be kind to let us know of it.

Addendum 22 Jan: Several readers have written to suggest that the Fed is buying in the TBA markets, new issues, and that they have fixed settlement dates that roughly coincide with stock options expiration. That does not remove the potential material effect of providing liquidity in options expiry week, but it certainly does nullify the imputation of deliberation. I think the front running as noted in the blog today in Treasuries is more obvious and plausible.

See Also About Those MBS Purchases in Option Expiry

But otherwise, it would be a good question to ask of the Fed. Are they in fact supplying extra liquidity to the banks at certain intervals to support a manipulation of the market to boost their prop trading results?

Perhaps at the next occasion of Ben's visit to Congress. Or maybe the SEC can pick up the phone and call NY Fed CEO Bill Dudley, formerly of Goldman Sachs. Federal Reserve Bank of New York Tel: (212) 720-5000.

ContraryInvestor is one of the more 'squared away' analysts we follow, and they do go to some pains to stress their reluctance to ever take the conspiratorial route. There may be a perfectly innocent reason why the Fed buys the MBS when it does. Some correlation based on the calendar.

Inquiring minds would like to hear all about it, Revelations-wise.

"...in trying to follow the money we know the bulk of Fed money printing has gone to support the mortgage markets with the Fed buying up a huge swath of MBS since March of last year. From the summer of 2008 until the present, the Fed has been a huge help in getting conventional 30 year mortgage paper costs from the mid-6% range to the high 4% range. Quite the accomplishment.

But if you take a very careful look at the character of the Fed balance sheet since the big time money printing effort started in March of 2009, you'll see that their buying of MBS has been a bit of a multi-use exercise. Without trying to sound conspiratorial, we believe they have also used the MBS buying program to help "support" equity prices by essentially providing liquidity to the aggregate financial market at quite the opportune times...

You may have seen that recently Charley Biderman at MarketTrimTabs has been suggesting that he cannot account in aggregate for just who has been buying equities since March of last year. He suggests that although he cannot prove it, the Fed may indeed be a key buyer. MarketTrimTabs is the keeper of the records of the kingdom when looking at equity mutual fund flows, etc. We even did a bit of this ourselves in a discussion a while back by documenting that traditional equity buyers that have been households and corporations (buybacks) were essentially nowhere to be found in 2009.

In fact, households were selling and on a net basis corporations were issuing equity, not buying it back. That leaves institutions, banking sector prop desks, the hedge community, etc. as the key provocateurs of equity price movements in the rally to date. No wonder Charley is scratching his head a bit and wondering just how we could have scaled the largest 10 month rally in market history without households and corporations playing along. But like Charley, we can prove nothing about the Fed actually acting to buy equities or futures, etc.

But there just happens to be one thing we can prove when we “follow the money” that the Fed has been doing. And it ties right back to their purchasing of MBS in the marketplace. Remember, when the Fed buys a mortgage backed security from the financial sector, it provides liquidity that can 1) be lent out, 2) reinvested in other mortgage backed securities (not a chance), 3) used to buy bonds, or 4) used in prop desk trading. We already know the lending is not happening, MBS purchases have been the province of the Fed with few other buyers, banks have bought bonds, but in moderation, and finally banks are announcing “record trading profits” as per their prop desk activities. Get it? Of course you do. The prop desk destination has been a liquidity magnet.

So here’s the important issue regarding the Fed's MBS purchases relative to equity market outcomes. It’s the timing of the Fed’s MBS purchases that has been the key support to equity prices. And we see it that way when we analytically follow the money. Ok, the chart below chronicles ALL Fed purchases of MBS by the week since March of last year. The blue line is the ongoing level of Fed ownership of MBS as this position has been accumulated over the last 10 months. It’s an almost perfect stair step higher pattern. Although it may seem random, the dates we input into the chart happen to be the weeks ending on a Friday. Friday's of options expiration weeks. Notice a pattern here?



Of course you do. It’s blatantly obvious. To the bottom line, the Fed has been very significantly goosing its purchases of MBS during equity options expiration weeks. In fact, since July, there has only been one options expiration week whereby the Fed did not buy at least $60 billion of MBS during the options expiration week itself, providing instant and meaningful liquidity during options expiration weeks that have historically had an upward bias anyway! Talk about timing of liquidity injections to get maximum effect in the equities market.

Folks, this is right out in the open. No mysteries and fully disclosed on the Fed’s own balance sheet. And guess what? It gets better. The second largest weekly period for Fed purchases of MBS outside of the expiration week itself? You guessed it - month end week. Another maximum effect week where we usually see institutions engage in a bit of window dressing. Nothing like providing a few extra chips "on the house", no?



To put a little summation sign around this section of commentary, the chart below breaks down the timing of Fed purchasing of MBS since June of last year. Yes, 86% of all Fed purchases of MBS since that time occurred directly in equity options expirations weeks. Another 7.8% of total MBS purchases occurred in final weeks of each month. And an overwhelming 5.8% of total Fed purchases of MBS occurred at other times.

In following the money, this is the only thing we can prove in terms of actual Fed actions relative to the equity market itself. A mere coincidence? Not a chance. As we see it, the Fed printing of dough to buy back MBS has had a dual purpose. The ultimate new age definition of cross-marketing? Yeah, something like that.

Now that we have covered this data, the question of "what happens when the Fed stops printing money in March?" takes on much broader meaning and significance. Of course the Fed has not directly been buying equities with their clever and clearly very selective timing of MBS purchases, but they sure as heck were providing the immediate and sizable liquidity for "some one else" to do so during equity periods where they could achieve "maximum effect".

Wildly enough, at least as of last week's option-ex, the Fed was still purchasing $60B in MBS. So, as we stand here today, there are now two more options expirations weeks prior to us theoretically reaching the end of the game for Fed printing and MBS buying. You already know we'll be watching, errr.. following the money that is.

When/if the Fed stops printing to buy MBS, do we also lose an options expiration week and month end equity liquidity sponsor? Something we suggest you think about as we move forward. See why we suggest following the money is a key theme?

Goldman Expects to Keep Cake, Eat Same, Stick Public with Tab

Dick Bove says that Obama's proposal will be good for Goldman Sachs because it will take away the prop trading from banks that have deposits, but will not affect Goldman Sachs who will once again eliminate more competition.

So buy the stock. Hard to imagine anything short of Armageddon that would cause the word 'sell' to emanate from his bloviateness when he is talking his book.

And Goldman Sachs says that it is 'unrealistic' to take away their place at the Fed's teats as a subsidy sucking bank holding company.

"Goldman Sachs Chief Financial Officer David Viniar said it’s “unrealistic” to imagine the firm won’t be a federally supervised bank, even as new regulatory proposals cast doubt on that status."

Perhaps they will lobby for a special category of bank. Some banks are more equal than others? The public might be dumb enough to buy it, but doubtful Lloyd's peers on the Street would not raise a fuss.

More likely that the corrupt Congress takes this idea of Volcker's, and leads it up a blind alley, and strangles it with delays, transitions, and deceptions, and grandiose discussion of new regulatory architectures, rather than simple but elegant focus on primary mission, and the elimination of conflicts of interest.

The threats of 'lack of competitiveness,' 'stifling the recovery,' and 'portfolio diversity' are already resounding from the canyons of Wall Street and their pond skimming sibyls on financial television.

Bloomberg
Goldman Will Benefit From Obama’s Proposal, Bove Says
By Rita Nazareth

Jan. 21 (Bloomberg) -- Goldman Sachs Group Inc. will benefit from President Barack Obama’s proposal to limit Wall Street risk because it may force deposit-taking banks to unwind trading operations, Rochdale Securities analyst Dick Bove said.

Obama called for limiting the size and trading activities of financial institutions as a way to reduce the risk of another financial crisis. The proposals would prohibit banks from running proprietary trading operations solely for their own profit and sponsoring hedge funds and private equity funds.

He also proposed expanding a 10 percent market-share cap on deposits to include other liabilities such as non-deposit funding as a way to restrict growth and consolidation.

“Banks with large deposit bases have distinct advantages in certain sectors of the market,” Bove wrote in a report today. “If the banks are told they cannot use deposits in this fashion in the future, it ‘levels the playing field’ for companies like Goldman Sachs. This is not a time to sell this stock, it is a time to buy it.”

Goldman Sachs shares erased an early advance as Obama prepared to outline his proposal. The shares lost 4 percent to $161.15 in New York at 2:56 p.m. after rising as much as 1.9 percent at the start of trading.

Bonus Pool Slashed

Goldman, the most profitable securities firm in Wall Street history, reported record earnings that beat analysts’ estimates as the bank slashed its bonus pool. Net income of $4.95 billion, or $8.20 per share, for the three months ended Dec. 31 compared with a loss of $2.12 billion, or $4.97 a share, for the same period in 2008. The average estimate of analysts in a Bloomberg survey was $5.18 a share.

The record profit came as Goldman Sachs, facing criticism from politicians and labor unions for near-record compensation, set aside $16.2 billion to pay employees, the smallest portion of revenue since the firm went public in 1999.

“The adjustment of compensation lower leaves more money for shareholders,” Bove wrote.

Bove said that if the bank had not slashed its bonus pool, earnings may have been only about 3 cents to 5 cents a share in the quarter, “under certain assumptions concerning compensation,” because of a slowdown in trading.

“Investors are reacting sharply to the fourth quarter results at this company,” Bove wrote. “However, all indicators -- M&A, new financings, increasing volatility in a number of markets, growth in the money supply -- all suggest that this quarter may be a one-time event.”

Goldman Sachs Chief Financial Officer David Viniar said it’s “unrealistic” to imagine the firm won’t be a federally supervised bank, even as new regulatory proposals cast doubt on that status.