As with many others, I’m keenly interested in what happens when the Fed’s QE2 program ends. Will there be a QE3? Will the markets crash without the Fed in there proffering support? Will anyone even notice what the Fed does if Charlie Sheen keeps talking?
One thing I’m wondering is this, and I don’t have a good answer for it although I’m asking around: let’s say the Fed decides not to do another round of asset purchases. It’s still sitting on more than $2 trillion of securities. Let’s say the Fed decides to hold them to maturity, something that been talked about. If that’s the case, sans a bond-selling program that would effectively drain some of the liquidity it put out there, the Fed can sit on its zero-percent interest rates and bloated balance sheet and still have interest rates that are negative on an inflation adjusted basis.
In other words, they don’t need to do a QE3 to still be very loose with their policies. There are issues of timing and reinvesting maturing debt on the balance sheet, but in general I think the Fed can keep monetary policy wide open without undertaking another big program.
It seems reasonable to me to see it that way, but I don’t have a PhD in economics. Actually, I don’t have a PhD in anything, but that’s another story. Gluskin Sheff’s David Rosenberg has contemplated a world without QE3, and comes to the conclusion that it’ll look a lot like the world without QE2, an era that lasted from approximately April to August 2010.
WHAT HAPPENS IF THERE IS NO QE3?
We are now being asked this constantly and the follow-up is “who picks up the slack if the Fed stops its bond-buying program”?
The answer(s) is hardly complicated since we have a template for this in 2010. It is a very simple guidepost.
Last year, from April 23rd through to August 27th, the Fed allowed its balance sheet to shrink from $1.207 trillion to $1.057 trillion for a 12% contraction as QE1 drew to a close. Go back a year to the Federal Open Market Committee minutes and you will see a Federal Reserve consumed with forecasts of sustainable growth and exit strategy plans. A sizeable equity correction coupled with double-dip fears were nowhere to be found.
Now over that interval …
• S&P 500 sagged from 1,217 to 1,064.
• S&P 600 small caps fell from 394 to 330.
• The best performing equity sectors were telecom services, utilities, consumer staples, and health care. In other words — the defensives. The worst performers were financials, tech, energy, and consumer discretionary.
• Baa spreads widened +56bps from 237bps to 296bps
• CRB futures dropped from 279 to 267.
• Oil went from $84.30 a barrel to $75.20.
• The VIX index jumped from 16.6 to 24.5.
• The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5.
• Gold was the commodity that bucked the trend as it acted as a refuge at a time of intensifying economic and financial uncertainty — to $1,235 an ounce from $1,140 and even with a more stable-to-strong U.S. dollar too.
• The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%.
So you see, the bond market actually does better (same was true during QE1) without the Fed balance sheet expansion than with it. Why? Because the Fed’s real goal is to ignite investor risk appetite. Bernanke et all have not kept it a secret that the real aim of the QEs is to generate a liquidity-induced rally in the equity market. If bond yields end up rising as they have for most of the past six months but occurs with a rising stock market and greater economic strength, then the Fed is totally cool with that and again Mr. Bernanke has stated that very bluntly (even if the higher mortgage rates that ensue drive another knife into the heart of the housing market). When the Fed stops QE, as we saw last year, risk appetite fades and the economy sputters — a development that will likely be even more acute this time around given the accelerating fiscal restraint at all levels of government that is just around the corner.
So who buys the bonds when Ben leaves the building?
The same folks who were the buyers last year from April to August. The ones who were switching out of equities, commodities, and other risk-assets.
Now you know how to play the second half of the year!