Friday, October 22, 2010

What’s a POMO, and Why Does it Matter?

Lately there’s been a new acronym running through investment research we have been reading, and it is “POMO.” POMO stands for Permanent Open Market Operation. When you hear the Fed is executing a POMO for a certain amount, they are simply buying Treasury securities and the proceeds add reserves to the banking system permanently, as opposed to other temporary measures they may use. The Fed is entering into these transactions to ensure that its balance sheet doesn’t contract at a time when economic growth is still lagging, and price stability is at risk to lower prices.

For weeks the Fed has been using these POMOs, and we’ve been reading certain analysts that believe the market is reacting to the size of the daily POMOs. We recently asked one of the analysts we follow, Bill King, why he thought these POMOs mattered so much to the markets given the fact that the Fed is simply maintaining the size of the balance sheet. Below is a summarized version of Bill’s response to our question.

1. The Fed is entering into larger POMO’s than necessary to account for the bleed off of agency mortgage-backed securities. In his opinion, the first round of quantitative easing (QE1) never ended.

2. Money desks that control Wall Street must invest this new liquidity in the system, and at very highly leveraged multiples.

3. Traders respond reflexively to more juice equaling higher assets prices.

At Pinnacle Advisory Group, we can’t claim to know exactly how much POMOs are affecting daily movements in the market. But we can claim to constantly be evaluating and adjusting our views of financial markets based on new information and constantly changing conditions.