The curve was mixed throughout the week with the short-end finishing about where it started and longer-term bonds at higher yields despite closing the week off the lows in price. Cautious buying at auctions this week managed to take down $99 billion in coupon Treasurys, with the best results coming at the seven-year auction The seven year sector is also expected to be a major area of interest for the Fed come QE2, yet another sign that the Fed is completely controlling the market right now.

The initial GDP reading for the third quarter showed Core PCE, the Fed’s preferred measure of inflation, rose .8% from last quarter, below the 1% increase that the street expected. Bernanke hasn’t wasted one opportunity in the past six months to say that higher levels of inflation are a main goal of the Fed right now. When the comments from next week’s meeting are released on Wednesday, count on the weak inflation readings of late to be mentioned. Longer-term bonds rallied after the data on Friday as traders positioned themselves ahead of Fed buying.

Trick or POMO?

We will get the official announcement on QE2 next week from the FOMC, and expectations are leaning now toward a less aggressive start to the program. Opinions are still in a wide range, but consensus is for an announcement of $500 billion to $1 trillion over the next six months or so.

Speculation early on Monday got the market juiced, when rumors of 2-3 trillion dollars of Fed buying spread across the street, but that chatter quickly died down as a more measured approach by the Fed gained more traction in the market. The Fed floated the idea of less buying through an article by John Hilsenrath in Tuesday’s Wall Street Journal. The article sparked a selloff in Treasuries that led to a 15 basis point upward move in the ten-year yield to just over 2.70% on Wednesday, the highest seen since September 21. That’s not an epic move, but it tells you that traders are willing to take some money off the table in case the Fed doesn’t come through as expected. It’s hard to believe buy and hold investors are buying the 10-year right now, so the market will continue to be choppy as the short-term traders struggle to correctly price in the Fed’s next move.

Speaking of traders holding the cards, Bloomberg revealed on Wednesday that the New York Fed sent inquiries to Primary Dealers asking them for their opinions on what the size and duration of QE2 should be. That’s a real confidence booster. Will the Fed ask the 18 Primary Dealers when they should start pulling back stimulus too? Confidence in the Fed’s aptitude and independence is already dangerously low and this only worsens things. (I say “dangerously” because without the public’s confidence a central bank controlling a fiat currency is useless.)

Whenever Chairman Bernanke is asked about the potential negatives over further monetary easing, (i.e. runaway inflation and another asset bubble), he remains confident in the Fed’s ability to reverse course when the time is appropriate. I find it hard to believe assurances like that when he is probing bond traders for their input on monetary policy at such a critical point in the cycle. The meeting is in three days, one would think they have a good idea by now… right? Next week will certainly be interesting.

Have a great weekend. 

Cliff J. Reynolds Jr., Investment Analyst