Blast From The "No QE Exit" Past

Almost 4 years ago, The FT's Mike Mackenzie penned a very prophetic article explaining exactly the dilemma the Fed is now facing: "No matter how bulled up the equity market becomes, should data improve, the Fed is likely to remain very cautious, mindful that it needs to keep the bond market happy. Becoming the buyer of last resort in the past year resulted in the Fed crossing an important line in the bond market." The full piece is well worth a read as a reminder that plenty of people saw this coming, Mackenzie concludes: "the eventual end of QE will be a messier affair than perhaps many investors care to think. And one that bodes ill for the dollar and US fiscal policy down the road."

Via The FT's Mike Mackenzie (January 9th 2010),

Equity and commodity markets have exuded confidence lately that a V-shaped recovery beckons this year - but not so the US Federal Reserve.

This week the Fed's meeting minutes from December painted a dour picture of just moderate growth and tame inflation, which is at odds with the more bullish forecasts emanating from private sector economists.

Away from the gleaming towers of Wall Street, the central bank frets about commercial real estate and the reluctance of companies to start hiring, particularly small businesses that face tight credit conditions from cash-laden banks. At the same time it is pondering how the economy and interest rates will fare once support measures end.

In fairness to the Fed, having slashed interest rates to near-zero per cent and embarked on buying bonds ("quantitative easing" or QE) in order to bring the financial system back from the brink of collapse, it is not surprising that it remains very cautious about the outlook for growth and inflation.

Yesterday's employment report for December showing the loss of 85,000 jobs suggests the Fed will remain wary for some time.

But, policy-makers are in a very difficult position and it is one of their own making. Under QE, the Fed has spent the past year buying much of a planned $1,700bn in bonds, and the forthcoming completion of this policy in March is already making waves.

Since early December, the yield on 10-year Treasury notes has risen from about 3.2 per cent and briefly hit 3.9 per cent this week. This, in part, reflects an end to the Fed's bond buying.

Calculating the arithmetic on where interest rates are heading looks like a slam dunk. During 2009, the Fed's purchases of bonds meant that the private sector had to absorb only $200bn of net new marketable debt, according to Morgan Stanley.

For 2010, with the Fed on the sidelines, the market will have to find a home for more than $2,000bn of net issuance.

Now, economic recoveries are tricky events and just how fast interest rates rise is crucial. Once the replenishment of low inventories has provided a nice short-term bump in activity, it remains to be seen just how well the economy performs.

A sharp jump in long-term rates on the back of an inventory-led rebound will not help the still-fragile housing market, so it's really no surprise that the December minutes raised the possibility that the Fed's bond buying spree under QE might not end in March.

The prospect of the central bank actually selling some of its mortgage portfolio is also off the table.

No matter how bulled up the equity market becomes, should data improve, the Fed is likely to remain very cautious, mindful that it needs to keep the bond market happy.

Becoming the buyer of last resort in the past year resulted in the Fed crossing an important line in the bond market.

The exit from QE is always going to be messy, unlike the relatively simple act of raising the overnight target interest rate. It leaves policymakers hoping that talk of extending QE will help contain rates from rising too quickly and save them the trouble of actually buying more bonds.

The danger, however, is that the bond market seeks a resumption of buying. A lot of easy money was made on Wall Street bond desks last year thanks to the Fed's buying. Can you blame dealers for not wanting to see that party end?

This potentially leaves the Fed trapped, for any sign of a recovery in the economy will be accompanied by rising rates, which in turn threaten sustainable growth and could well shake the equity market.

To prevent such a scenario, it is very likely that the Fed will reinforce its role as the buyer of last resort.

All which entails that the eventual end of QE will be a messier affair than perhaps many investors care to think. And one that bodes ill for the dollar and US fiscal policy down the road.