To QE or not to QE?
The Federal Reserve’s (Fed’s) policymaking arm, the
Federal Open Market Committee (FOMC) highlights this week’s relative busy
mid-month economic and policy calendar. We take a closer look at Fed policy in
this week’s publication. Elsewhere, after larger-than-expected rate cuts last
week by central banks in Brazil and India, rate setting meetings are scheduled
this week in Mexico, Norway, Switzerland and Japan. This week’s economic
calendar includes U.S. reports on manufacturing (Philly Fed and Empire State)
for March, industrial production in February, and consumer and producer prices
in February. Rising gasoline prices will grab the headlines in these reports.
Markets will continue to digest last week’s economic reports for February in
China, as well as a full docket of European economic reports for January and
February. Japan will likely be in the news this week as the one-year
anniversary of the earthquake, tsunami and nuclear disaster is recalled. There
are several bond auctions in Europe this week, and European finance ministers
will meet to discuss the €14.5 bond maturity Greece faces on March 20.
Will the Next Round of QE Be
“Sterilized?”
Operation Twist — an effort by the Federal Reserve
(Fed) to keep 10-year Treasury yields low by selling its short-term Treasury
holdings and purchasing longer-term Treasuries in the open market — is set to
end at the end of June 2012. Markets are now sizing up the likelihood of
another round of monetary stimulus from the Fed, following quantitative easing
1 (QE1) (2008 – 2010), QE2 (2010 – 2011), and Operation Twist (2011 – 2012).
Quantitative easing refers to large-scale bond purchases, consisting of
Treasury or agency mortgage-backed securities (or both) by the Fed in the open
market.
Our view is that another round of stimulus from the
Fed, in whatever form it takes, is data dependent. We also think political
hurdles — both inside the Fed and among the Fed’s bosses in Congress — have
been the largest impediment to another dose of quantitative easing. Events last
week (March 5 – 9) suggest that the Fed may have found a way to lower those
political hurdles a bit.
In short, if we see robust economic growth (3 – 4%)
between now and the end of June 2012, we would expect the Fed to hold off on
another round of quantitative easing (QE). But the current pace of growth (2%)
or slower growth would likely lead to another dose of stimulus.
Federal Reserve officials hinted in a well-placed
and well-timed Wall Street Journal article last week that the next round of QE
would be “sterilized.” This means that the Fed would immediately borrow back
some of the cash it injects into the financial system as it purchases the
securities in the open market. The Fed hopes to address one of the main political
hurdles to another round of QE: the long-held fear that more monetary stimulus
would trigger a surge in commodity prices and inflation. (We note that the WSJ
article was published just a week before the upcoming March 13 Federal Open
Market Committee [FOMC] meeting).
Politics Plays an Even Bigger Role in
Policy in a Presidential Election Year
For many in the political class in Washington (and
for the public at large), sterilized QE would not be regarded as inflationary,
and the Fed would face less of a public relations battle should it decide to
pursue that course of action. Of course, politics is nearly unavoidable in
Washington, DC in any year. But in a presidential election year, politics often
plays an even bigger role in policy — even when it comes to the Fed, which has
been viewed in recent years (last 30) as a nonpolitical and independent
organization.
For the record, the Fed has either raised or lowered
(and in some cases both in the same year!) its short-term policy rate in every
single presidential election year starting in 1968. In general, the Fed wants
to avoid mingling in politics during an election year, and it may prefer to
hold off on changing rates in the months just prior to the election in
November. But when push came to shove over the past 40-plus years, the Fed
acted to change policy as conditions warranted and is likely to do so again
this year if conditions warrant.
Breaking Down the Fed’s Menu of
Options
The Fed has two more FOMC meetings (this Tuesday,
March 13 and the two-day meeting at the end of April) to discuss another round
of stimulus before Operation Twist ends at the end of June. As it is only a
one-day meeting, a decision is unlikely to be made at this week’s FOMC meeting.
But if history is any guide a discussion of the full range of options open to
the Fed is likely at this week’s meeting. The market will get a scrubbed
version of the minutes of this week’s FOMC meeting in three weeks’ time, on
April 3.
As it stands now: 1) doing nothing; 2) extending
Operation Twist or embarking on QE3, but sterilizing the purchases; 3) or doing
a non-sterilized version of QE3 seem to be on the menu of options. Last week’s
WSJ article suggests that if the Fed does decide that the economy needs more
QE, it will likely pursue sterilized QE.
By allowing Operation Twist to expire at the end of
June, the Fed would probably be signaling that it is comfortable with a steady
climb higher in longer dated Treasury yields, which in turn would push
borrowing rates for consumers and businesses higher. We have noted in other LPL
Financial Research publications that Operation Twist has been quite successful.
We have highlighted that it is one of the key reasons why the 10-year note
yield has remained near 2% in the past six months, despite less volatility in
Europe, firmer U.S. economic activity and sizable gains in the U.S. equity
markets.
Extending Operation Twist would help to keep the
10-year note yield (and likely consumer and business loan rates) lower than otherwise.
However, there are some technical impediments, as the Fed (and Treasury) is
running low on short dated debt to sell in order to fund purchases of longer
dated Treasuries.
That leaves QE3 sterilized and QE3 non-sterilized as
options. In either case, the Fed has hinted in recent months that the mortgage
market would be a bigger target for QE3 than it was in QE2 (no MBS purchases)
or in QE1 when the Fed bought both MBS and Treasuries in the open market.
Risks and Rewards of QE3 Are Being
Carefully Considered
Questions remain (inside and outside the Fed) about
the efficacy of doing another round of QE. Fed Chairman Ben Bernanke has made
it clear that the FOMC carefully weighs the risk against the benefits of doing
more QE. The risk/reward trade-off may be even less clear-cut when weighing
sterilized QE3. Past examples of sterilized QE (Japan or Europe) have had mixed
results at best. The Fed borrowing to buy safe assets from the private sector
encourages private investors to take on more risk (which could potentially help
the economy). The degree of market impact is potentially greater than with
Operation Twist. Unlike with Operation Twist, sterilized QE doesn’t change the
mix of assets already on the Fed’s balance sheet. It adds the new assets the Fed
is purchasing, and the borrowing to fund those purchases gets added as
liabilities. So the impact on the assets is the same as in an unsterilized QE.
Will the Fed do it? We believe the odds strongly
favor a sterilized QE. A few months of weaker economic data would get the Fed
there, since the economy will likely come in below Fed expectations (FOMC sees
2.5% GDP this year and 3.0% next year), and making it "sterilized"
eases a political hurdle about future inflationary consequences. With oil prices
high and economic data softening around the world, a modest dip in the data
could prompt action.
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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are
not intended to provide specific advice or recommendations for any individual.
To determine which investment(s) may be appropriate for you, consult your
financial advisor prior to investing. All performance reference is historical
and is no guarantee of future results. All indices are unmanaged and cannot be
invested into directly.
The economic
forecasts set forth in the presentation may not develop as predicted and there
can be no guarantee that strategies promoted will be successful.
Stock investing
involves risk including loss of principal.
International
investing involves special risks, such as currency fluctuation and political
instability, and may not be suitable for all investors.
Quantitative Easing
is a government monetary policy occasionally used to increase the money supply
by buying government securities or other securities from the market.
Quantitative easing increases the money supply by flooding financial
institutions with capital in an effort to promote increased lending and
liquidity.
The Federal Open
Market Committee action known as Operation Twist began in 1961. The intent was
to flatten the yield curve in order to promote capital inflows and strengthen
the dollar. The Fed utilized open market operations to shorten the maturity of
public debt in the open market. The action has subsequently been reexamined in
isolation and found to have been more effective than originally thought. As a
result of this reappraisal, similar action has been suggested as an alternative
to quantitative easing by central banks.
The Federal Open
Market Committee (FOMC), a committee within the Federal Reserve System, is
charged under the United States law with overseeing the nation’s open market
operations (i.e., the Fed’s buying and selling of United States Treasure
securities).
Treasuries: A
marketable, fixed-interest U.S. government debt security. Treasury bonds make
interest payments semi-annually and the income that holders receive is only
taxed at the federal level.
London Interbank
Offered Rate (LIBOR): An interest rate at which banks can borrow funds, in
marketable size, from other banks in the London interbank market. The LIBOR is
fixed on a daily basis by the British Bankers' Association. The LIBOR is
derived from a filtered average of the world's most creditworthy banks'
interbank deposit rates for larger loans with maturities between overnight and
one full year.
This research
material has been prepared by LPL Financial.
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