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Originally sent to clients April 26.
By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab. 25 basis point policy rates for an “extended period of time” may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to reenter a Treasury market at today’s artificially low yields. Yields may have to go higher, maybe even much higher to attract buying interest.
As the Fed meets ahead of its decision on monetary policy tomorrow afternoon, investors are turning their attention to what happens when QE2 ends. There are a number of divergent views.
The most common view is that the end of QE2 is a non-event. According to this view, the economic recovery is now self sustaining and strong earnings will support the stock market going forward. Larry Kantor, Head of Research at Barclays, is in this camp: “It’s not the beginning of the Fed tightening, it’s the end of the Fed easing” (quoted in “Fed Searches For Next Step”, The Wall Street Journal, April 25, A1).
The next most popular perspective is that the end of QE2 means rising interest rates. This is the view associated with Bill Gross and PIMCO. The logic is straightforward. Since the onset of QE2, the Fed has purchased 70% of the annualized treasury issuance. Basic economics tells us that when you remove a huge source of demand from any market, price goes down. Since bond prices and interest rates are inversely related, that means rising rates. (I first discussed Gross’s argument in “Top Gun FP Client Note: The Charlie Sheen Market”, March 8, 2011).
However, a minority of bond market giants counterintuitively believe that the end of QE2 will result in lower interest rates. Rick Reider of BlackRock and Jeff Gundlach of DoubleLine are in this camp. On the surface, this seems to defy logic. Gross’s argument that decreased demand means lower prices and higher rates is straight out of Econ 101.
But these pros point out that the recent history with QE1 and QE2 does not fit neatly into this explanatory framework. Rates actually rose quite substantially during both QE1 and QE2. When QE1 ended on March 31, 2010, the 10 year treasury peaked out at 4% a few days later and dropped 160 basis points over the next six months as Gundlach pointed out two weeks ago on CNBC.
The reasoning is counterintuitive, nuanced and brilliant. In the last 30 years, Wall Street has learned that the Fed will intervene to bail out financial markets in almost any crisis. Starting with Continental Illinois in 1984, through the Fed’s assurances to the market in the wake of the 1987 Crash and the bailout of Long Term Capital Management in 1998, to the most recent interventions in 2008 and 2009, it has become an axiom on Wall Street: Don’t Fight The Fed.
This has created a sort of “risk on” mentality, especially when Fed policy is easy. The last two years have been a microcosm of this. Risk assets performed beautifully during QE1 but sold off and languished after it expired. They picked up again when Bernanke dropped hints about the coming of QE2 in late August 2010 and have been on fire since.
Were the playbook to repeat itself, the end of QE2 would cause a selloff in risk assets. We should expect stocks – especially small caps, cyclicals and emerging markets – and commodities to selloff. Because treasuries are perceived as “safe haven” assets – even “risk free” – a selloff in risk assets usually corresponds to an increased appetite for treasuries. That’s how these pros see the end of QE2 resulting in lower interest rates.
I think the two views can be synthesized. Reider and Gundlach are clearly right about the recent history and my sense is they will be right about the immediate aftermath of QE2. Over the longer term, Gross’s economic logic is sound. We are running trillion dollar deficits and will surely have to pay higher interest rates to fund them in the future.
John Burbank, head of San Francisco-based multi-billion dollar hedge fund Passport Capital, also thinks the end of QE2 means a correction for risk assets. But he takes his analysis a step further, forecasting the Fed’s reaction in the event of a post-QE2 correction: “I don’t think the Fed will tolerate a situation where asset prices are meaningfully lower, and that’s when we get a version of QE3” (“With Fed Effort Set To End, Some See Round 3”, The Wall Street Journal, April 25, C3).
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