The two mega events of the week, the election and the FOMC statement, were the main drivers of market action this week. The market read the election results as a positive, but the real possibility of pro-business legislation coming from a split congress is still unknown. Congressional deadlock, traditionally seen as a positive for the market, is getting the “this time is different” treatment and the market is sending mixed signals on the expectation front. The proximity of the mid-terms to an especially important FOMC meeting kept traders holding their breath for another day post election. More on the FOMC below.

It Happened

The FOMC finally announced the details of QE2 this week. The Fed will purchase $600 billion in Treasuries over the next 8 months while continuing to reinvest MBS paydowns, for a total of about $105 billion per month through June 2011. Although they announced $600B, they left the final figure open ended and also said they would be willing to stop early if future data warranted.

The QE program came in as expected, but the devil was in the details. The market was expecting a larger weighting toward longer bonds but the FRBNY only allocated 6% to the 10-30 year sector. The curve steepened to 158 basis points 10s to 30s post announcement, and over 300 basis points 5s to 30s. The traditional yield curve measurement, 2s to 10s, actually flattened on the QE2 announcement but thanks to the selloff in the long bond we have a seriously steep yield curve.

Reaction to the announcement in non-treasury bond sectors wasn’t as large. There were a few in the market that were expecting MBS purchases to be part of QE2 – they were disappointed and mortgages cheapened a little relative to Treasurys as a result. Credits spreads tightened a bit, and are likely to continue to tighten as long as emergency levels of liquidity remain in the market.

The Fed is furiously driving investors out of safer asset classes, and QE2 is just another step toward the planned elimination risk premiums in the market. That should be no surprise at this point.

Have a great weekend.