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Tuesday November 2, 2010 - 19:02:42 GMT
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I think by now there is no debate over whether the Fed sets sail on QE2.  That decision was largely made in late August when the Chairman delivered his speech to the KC Fed Jackson Hole conference.  And due to the Fed’s rather arcane form of communicating to markets ahead of key policy changes we roughly know the Fed will announce a monthly purchase plan that approaches $100bln a month in government paper (2-yr to 10-yr).  This is on top of the nearly $10bln a month the Fed is already buying in US Treasuries from proceeds from maturing MBS and UST holdings bought under the Fed’s $1.7trln QE1 program (LSAP).  While it is not the entirety of new US Treasury monthly supply, buying around $110bln a month in US gvt debt is a huge piece of the market.  Moreover the drop in mortgage rates has prompted waves of refinancing which means prepayments are up on agency MBS the Fed bought in 2009 and could make for even more than $10bln a month from this channel in UST purchases.


SOMA Security Limitation

As it is now, the Fed has a self-imposed limit on the percentage of any security (CUSIP) it purchases…35%.  QE2 is perhaps problematic if the SOMA (Fed’s System Open Market Account) limits are a constraint on what the Fed buys, particularly if it focuses on the 2-yr to 10yr area of the curve.  So more than a few Fed watchers expect the limit to be bumped up to 50% to give the Fed more degrees of freedom in buying assets.  My guess is this change would come in a special announcement after the release of the FOMC statement (more a operational change as opposed to monetary policy change).   This change makes some difference to bond traders who have a pretty good idea of the liquidity and supply in all the different issues and could make for some upside in 2-7-yr portion of curve if announced.



There have been indications from Fed officials including Bernanke that the Fed could announce a target for the price level, rate of inflation or nominal GDP which would make the promise to keep rates low for an extended period moot and link this promise to some quantitative target giving the zero rate promise a far longer shelf life than the current promise.  However, the Fed is not yet expected to embrace a quantitative target as it is controversial (which one to adopt) and so open ended that some worry it may tie the Fed’s hands and or play into a far more massive end total for QE2 as many question the ability of QE to impact employment and prices (in a liquidity trap).  Nevertheless, the key rationale for QE2 is that the Fed is revising down its central tendency forecasts for growth and inflation ahead (in light of the dual mandate, demands action, even action that has highly uncertain impact…risk of doing nothing is greater than the risk of doing something and not having much impact).  So it is possible that the promise to keep rates low until inflation and unemployment move toward levels consistent with the dual mandate (2% core CPI and probably a 6% unemployment rate which has some structural unemployment built in).  The Fed will not publish its new economic forecasts Wednesday but will when the minutes of the November 02-03 FOMC meeting are released on November 24. 



It is also quite obvious that the Fed Chairman and his supporters on the FOMC want lots of wiggle room (degrees of freedom) on the scale and pace of QE2.  If the facts change the scale and pace of QE2 will change.  QE2 is the new Fed funds rate target and no easing or tightening cycle using the old interest rate target was ever laid bare at the beginning…work in progress.  This is why I have problems with how many in the market see this…$500, $800, $1,000 or $2,000 billion.  If the Fed has no idea how can the market?  Moreover, the election today is likely to result in an end to any major new government stimulus above and beyond the extension of the Bush tax cuts (I am betting on them being unfunded which will bloat the 2011 deficit and beyond).  But if the GOP lives up to its word and finances the tax cuts with spending cuts, then we are standing still on fiscal stimulus and if the new election message is wind down government spending and deficits, then we are entering a period of fiscal contraction at a time when the Fed is easing monetary policy in a liquidity trap…the economy will slow even more, making the Fed more likely to increase QE2 over time. 


Selling Message

Because the Fed is treading in unknown territory on QE2 and has loads of critics in the markets, Washington and inside the Fed, I think Bernanke will be very deliberate in how he sells the policy ahead to make it less controversial…downplay risks (from inflation, on asset prices) and emphasize gradualist approach (should not be confused with minimalist…there is nothing minimal about printing money).  Bernanke will speak Friday at the Atlanta Fed annual conference (appears Saturday on a panel with Greenspan).  But this program will be under the spotlight ahead ever more as the election is likely to bring GOP attention to bear on the Fed under the guise of getting government out of markets…what are you guys doing?   And Bernanke will also face escalating criticism from within his own ranks…Hoenig, Fisher, Plosser, Kocherlakota to name a few.  I think Bernanke will have a near impossible task ahead of convincing the public, Congress and markets that QE2 is a noninvasive pharmaceutical cure all that never had a clinical trial nor FDA approval.  And his medical and operating assumption is size matters…more = more impact.     


Effects on Dollar/Assets

One can’t help but think markets have done plenty of discounting of Wednesday’s FOMC statement since late August and the announcement effect is likely to prompt some profit taking (weaker risk assets, firmer dollar, weaker Treasuries).  But this is a work in progress and debt monetization trumps all else, including record wide CDS for EZ’s Club Med plus Ireland.  Moreover, the ECB which meets Thursday is likely to phase out unconventional policy accommodation early in 2011 and will likely start in Q1 with normalizing rates.  I can’t help but think that EURUSD trades north of 1.50 by year end.  And I doubt the BOJ can slow the decline in USDJPY much ahead even by matching Fed actions (BOJ moved its meeting up to Thursday and Friday this week to presumably respond to Fed QE2 to save the yen from itself).  And the Fed can’t rewrite the rulebook on monetization…its key policy channels are crowding investors into higher risk assets as savers are punished for holding cash and risk free assets (see last 5-yr TIPs auction result).  Debt monetization means risk assets go up and the currency of the money creator goes down.  Yes the easy money may have been made on this trade since late August but there is plenty of room left in the trade to ride a dollar decline ahead.  Surely we will see corrections and maybe some induced by verbal intervention from Geithner or currency intervention (unilateral by Japan…multilateral is still relatively remote).  Even with a near consensus view on the dollar, there are rare times like debt monetization by the world’s reserve currency central bank that justify a one-sided market and a sell on strength mentality.  This is one of those rare times.


David Gilmore





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