One of the problems with asset purchases by the Fed is how transparent Fed's actions can sometimes be. And when that happens, the Fed will overpay while someone on Wall Street will make easy money. Here is an example. Last year the Fed announced that it will maintain a constant balance of MBS positions. That means as securities' principal declines due to prepayments (mortgage refinancing), the Fed buys more (see this post).
Here is the pattern of buying the 30y Fannie Mae paper. The Fed is decreasing its purchases of the 3.5% coupon paper (green) and moving into the lower coupon (on the run) 3% coupon bonds (blue). The central bank is no longer buying the 4% bonds (red). It's fairly easy to predict the next set of purchases. A skilled agency bond trader could take advantage of this.
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| Fed's 30y Fannie Mae bond purchases (Source: BNP Paribas) |
And if the Fed commits to increasing its MBS holdings through further asset purchases, it's pretty clear that the central bank will lean on the 3% coupon bonds and the 2.5% when it becomes the on the run bond. Transparency is great, but the taxpayer needs to be protected while the asset purchase program is in place. Being just a bit less obvious would go a long way in making sure the "front-running" is limited.
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