QE2: Yabba Dabba Doooooooo!
October 24, 2010
David R. Kotok
The countdown to QE2 continues…
For weeks, various members of the Federal Open Market Committee (FOMC) have used the media to discuss their views of quantitative easing. In the first week of November and coincident with the outcome of the elections, they will emerge from a Fed meeting and we may hear a decision. Some pundits argue the electoral outcome is clearer than the 11-voting members, FOMC’s intentions. Senator Shelby is holding up confirmation of voter number 12.
For the financial markets, the FOMC members have definitely introduced uncertainty and thereby raised risk premia in the long-term US Treasury bond market. Yields on the 30-year Treasury bond have risen during this pre-meeting period of publicly debated policy. The Open Market Committee has been nicknamed the “open mouth committee.” As of this writing, no one has a clear expectation of the Fed’s forthcoming policy.
The range of views from FOMC members span from “do nothing” to “we must take significant action.” Estimates of the results of an action are narrowing. The first study we saw attempted to establish that a $100 billion addition of QE would reduce the yield on the ten-year Treasury note by seven basis points. Subsequent analysis lowered the impact to five bps. Another study took the number down to three. At the NABE meeting in Denver, several economists and practitioners engaged in serous discussion of this estimate. The consensus was that the number is closer to two.
Furthermore, there is an expectations component. In Denver, we speculated that about half of the outcome came from the open-mouth activities and preceded the actual open-market implementation of QE.
In the beginning of the QE discourse, there were estimates that a program would be forthcoming and the size of the program might be large. Recent open-mouth pronouncements seemed to have toned down that number. Some FOMC members suggested or implied that this would become a meeting-by-meeting decision.
Wall Street analysts vary but seem to bunch their estimates in a monthly range of $70-120 billion of asset purchases by the Fed. Some firms estimate the total will be as high as $700 billion spread over 6 months. Former Fed Governor Meyer is calling for $1.5 trillion. For reference, the US has about $100 billion a month of net new Treasury issuance. Therefore, if the Fed were to embark on a sequence of monthly purchases on that scale, it would be absorbing the entire federal deficit.
Would anything be accomplished by this plan? Many market practitioners seem to believe that interest rates would be lower than they otherwise would be and the dollar would be weaker than it would otherwise be. We believe that both outcomes seem likely; however, that is not a precise picture.
The US is the largest participant in the global markets but it is not the only one. Of the G4 currency group, one other is also engaged in large-scale asset purchases. That is Japan, and they have much more experience doing it than we do. The United Kingdom bears watching, too. Its monetary policy committee is experiencing an internal debate over QE. At the moment, the QE supporters are in the minority, but some London-based analysts expect them to arrive at a QE program within months. Only the European Central Bank (ECB) is avoiding QE. Nevertheless, President Trichet seems to worry aloud about what the policies of the other major powers are doing to the strengthening of the euro and how that strengthening will hurt an economic recovery in Europe.
Why is the G4 currency block so important? Simply put, the yen, pound, dollar and euro denominate about 90% of the world’s debt. They collectively define the world’s capital markets. All the others are important and nice places to visit but the G4 define global finance.
We expect there will be some form of QE announced at the November Fed meeting. After all this “open-mouth” policy discussion, if the Open Market Committee does nothing, it will have misled the financial markets and lose a great deal of its remaining credibility. Therefore, our conclusion is that something is coming.
If it is small and gradual, there is likely to be little impact. Moreover, what might have been the outcome may already be priced into the market.
If it is large and the announcement is clear, there may be market impact coincident with the announcement. The Fed has had this small vs. large experience in the past. When the Term Auction Facility (TAF) was originally announced (2008), it had little impact. It was too small to mean anything. The Fed’s first moves with the post-Lehman TAF policy were insignificant and tepid. Only when it was enlarged (early 2009) into the hundreds of billions with global swap lines, did the TAF meaningfully reverse the damage done during the Lehman-AIG fiasco phase of the crisis.
The same was true for the $1.25 trillion mortgage purchase program. Within days of the announcement, the mortgage market started to defrost. The Fed was believed and the market functionality resumed even though the Fed’s program spanned over a year to implement. In other words, it takes both large size and credible follow-through for the Fed to have a meaningful impact.
Steve Liesman’s survey on CNBC is one of the tools trying to measure the market’s expectations of QE. If Steve’s results are indicative of market expectations, the Fed will need to surpass the estimates in a decisive and meaningful way. That would mean $1 trillion or more in an announcement.
We will find out soon enough. One thing is certain. With all this talk about QE2, there is no expectation that the short-term interest rate will do anything but remain near zero. That is likely to be the case for a long time. By long time, we mean a period measured in months and maybe years. Cumberland’s portfolio strategy continues to evolve with the basic assumption that the zero boundary in short-term rates is here to stay for a while.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors