Markets continue to focus discussions around the Fed's comment at the conclusion of the FOMC meeting last week that it is"prepared" to do another easing move if economic conditions warrant it. Markets took the comment as eventual fact sending treasury yields lower and boosting interest in equity markets. Will QE 2 be announced when the Fed meets again on Nov 2 and 3? If we do get more easing what shape will it take? Two questions with a multitude of answers depending on who is talking. A new theory emerged yesterday based on an article in the NY Times, that the Fed may not just buy treasuries but may step into corporates and other investments. Open-ended easing allowing the Fed to ease or not as necessary.
Does QE increase inflation levels? The Fed is worrying that deflation may take hold and wants inflation to increase to norms at 1.0% to 2.0%. The problem is QE doesn't have much impact on inflation directly; the Fed isn't printing money, it just borrows money from Treasury to do easing. The two largest sources of borrowed funds for the Fed are bank reserves and Treasury cash. Banks now earn interest on reserve balances and hold roughly $1T at the Fed. At the same time, the Fed is borrowing $277B from the Treasury. It uses these funds to buy mortgages or Treasury bonds. This is not the creation of new money and therefore does not create inflation or lift aggregate demand. Bank reserves peaked in February 2010 at $1.2T, and have since fallen by $252B. Banks appear to be taking back these funds to make loans or buy bonds.
Prior to the FOMC’s November meeting, the central bank will see the October jobs report, the first take on third-quarter gross domestic product and another round of readings on housing, retail sales and consumer spending. There is the potential that the Q3 GDP will be slightly stronger than 1.6% GDP growth in Q2. Economic outlooks and forecasts are changing on almost every key data point recently and over the next month with QE 2 the wild card, market reactions on economic releases will likely increase volatility.
If the central bank goes forward with QE 2, it should in theory result in selling of Treasuries by investors who then move into higher-yielding debt and eventually spill over into equities. If the Fed sees enough growth that it doesn’t consider QE 2 necessary, the improved forecast for the economy is likely to be constructive for equities as well. What happens to interest rates if another easing is put in place? Do investors, still sitting on the sidelines for the most part, actually step up investing and if so where will money go? Many believe back into equities and higher yielding corporate bonds and in turn walk away from treasuries pushing rates higher. If that scenario plays out mortgage rates will head higher. Others believe more easing will suggest the Fed is increasingly concerned the economy is headed back to recession and investors will flock to safety and run away from equity markets, pushing interest rates a lot lower on treasuries. The take away now is that more uncertainty has been piled on already uncertain outlooks for investors and markets.
At 1:00 this afternoon Treasury will auction $29B of 7 yr notes. The 2 yr and 5 yr auctions yesterday and Monday went well as most Treasury auctions have done over the last two years; no reason to think this one will be any different.