Ramblings of a Portfolio Manager

Is QE2 Really Dead?

With Greece back in the headlines—and we’ve said quite enough on that subject--we thought we’d take the opportunity to talk a little about one of the other of the myriad concerns the US equity markets have been focused upon over the last two months—the coming end to QE2. Very few government actions have been so well telegraphed to the markets yet the equity, currency and bond markets have been roiling over the last two months as they fight to determine what, if anything, will be the exact effect of the end of the Federal Reserve’s program to support bond prices and keep interest rates and the dollar low with the purchase of US Treasuries.

QE2’s goal was to support asset prices through the purchase of $600 billion of US Government debt issues. The hope was that higher asset (equity, bond) prices would lead to the wealth effect among consumers and businesses alike, spurring spending and, eventually, production and hiring. Whether the program was a success or not remains to be seen. Of late we have received some fairly weak economic data from the US, including employment, which has called into doubt the efficacy of the program. Our thesis is that the effects of QE2 have a lag and that the full impact of higher asset prices and easy money has yet to kick in and be seen in US economic data. In the meantime, economic data, as it always is coming out of a recession, has been lumpy causing many to declare the program a failure. We choose to wait and see. In the meantime, while economists fret over the pending end to QE2 and the apparent lack of a successor, they ignore one very important artifact of the program from the outset—the Fed, now the largest owner of US Treasuries, is earning some decent interest rates on its purchases. In fact, the Fed’s balance sheet now stands at close to $2.9 trillion. With Fed Chairman Ben Bernanke declaring that it will be some time before the Federal Reserve begins to unload its considerable holdings in Treasuries, some pretty sizable interest payments will be hitting the Fed’s income statement. What will they do with all that money?

On June 22 the Fed concluded its monthly Open Market Committee meeting and Bernanke gave a rare press interview shortly thereafter. The takeaway for the markets, as we saw in equity price actions that day and the next, was that there would be no QE3, something many traders and economists alike were hoping for to continue to support asset prices. What was largely ignored, however, is that the Fed said on June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. Given the size of its balance sheet, that could mean purchases (reinvestment) of as much as $300 billion of government debt over the next 12 months without adding any additional money to the financial system. That means that the central bank will continue buying Treasuries to keep market rates down as the economy slows. And those purchases will continue to support demand at bond auctions while Obama and Republicans in Congress struggle to close the gap between federal spending and income by between $2 trillion and $4 trillion. So not only is the Fed maintaining its accommodative stance, it is, in effect, launching into an unofficial QE2.5—something the markets have yet to focus upon.
Of the Fed’s bond holdings, a total of $112.1 billion will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account. Just replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of debentures, the debt of government sponsored enterprises Fannie Mae and Freddie Mac. Estimates are that $10 billion to $16 billion will mature each month, depending on the pace of prepayments. That is yet more liquidity that will be reinvested into the system if the Fed decides to keep its balance sheet size the same, as it has openly declared.
Helping the Fed with its low interest rate policy has been the flight to quality by investors in the face of European debt concerns. Treasury 10-year yields fell to the lowest since Dec. 1 last week, down from this year’s high of 3.77 percent on Feb. 9. On June 24, the two-year yield came within one basis point of the record low, set November 2010, reaching 0.32 percent. And so far there’s been no lack of demand for government securities even as US Treasury debt has grown to $9.26 trillion from $4.5 trillion at the start of the financial crisis in August 2007, and $5.75 trillion when Obama took office in January 2009.
Most economists don’t expect that the Fed will raise its zero to 0.25 percent interest target rate for overnight loans between banks until the first quarter of next year. At his June 22 conference, Bernanke declared that the inflationary pressures we saw earlier this year are abating, in his opinion, and yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.2 percentage point inflation, up only modestly from the 1.5 percentage points the way back in August 2010, when Bernanke first indicated the central bank might resume debt purchases to fight deflation. That suggests the first interest rate hike may be well into next year—beyond Q1
Bottom line: the asset purchases the Fed must make, even if they occur on a smaller scale, over the next year still continues the strategy that the Fed was trying to accomplish in the first place. That means that even with the end of QE2, the liquidity flow and its fundamental impact will remain intact for some time to come. So even though the market is going through a correction in anticipation of QE2’s demise, we may very well see the resumption of the liquidity driven rally.