“So is the Fed short volatility? No, but that is the joke on all of us. Thanks to the Fed’s manipulation of the credit markets, we are all short-volatility.
So while the Fed is certainly long duration, we dear friends are short volatility thanks to QE. Or as Grant’s Interest Rate Observer said so well: “The Fed is selling, you are buying.” As the Fed ends its reinvestment of cash when bonds redeem, volatility will return to the markets, spreads will widen and trading by private investors will rebound. A lot of market participants will get their eyeballs ripped out when the weight of option-adjusted duration shifts back to private investors. Can’t wait.”
Whalen stresses that the Fed will not be selling assets but merely ending “its reinvestment of cash when securities are redeemed .. Yet as we and a growing number of investors seems to appreciate, the Fed cannot force up long-term rates so long as it is sitting on $4 trillion worth of securities that it does not hedge. More given that the Treasury intends to concentrate future debt issuance on short-term maturities, downward pressure on long-term bonds yields is likely to intensify.”