Saturday, June 4, 2011

QE3 - The Discussion

Fed Chairmen Ben Bernanke: "I'm not crying because
I'm a failure, really. I just got something in my eye."
The QE3 debate continues to rage with a few weeks until the scheduled end of QE2, this should get interesting. Of course, the multi-trillion dollar question is: Will the Fed end QE2 on schedule or begin a new iteration of easing (aka QE3/Money Printing)? Scenario 1 was previously discussed and can be found here.

The FOMC meeting will take place June 21st-22nd 2011. Here are the possible outcomes and  potential ramifications:

Interest Rates
The Federal Reserve will most likely reiterate its stance on interest rates saying that they'll keep them low for an extended period of time, but will also indicate its willingness to increase rates at a time in the future. It's possible that the Fed may even hint toward a time in the future that it will consider increasing rates. Of course, the objective will only be to give the impression of a hawkish stance. In reality, rates will be kept low for a very long time.

Why? There are few calls to modify the Fed rate as it's taking a backseat to the QE discussion. It would be something like putting the cart before the horse. Also, with a weakening economy, an increase in rates would put pressure on lending, deficit spending, the Fed balance sheet, and the economy as a whole. If the Fed raises rates and the economy deteriorates the Fed will be blamed. To summarize, the options are as follows: 
  1. Rate Increase: The economy will slow, the Fed will be blamed, the broken economy will be exposed, further confidence will be lost by the general public, fiscal or monetary stimulus will eventually be called for (especially in an election cycle), commodities, housing, and lending will take a tumble. Essentially, all the 'progress' made thus far will be lost very quickly. Please be aware that I'm using the word 'progress' extremely facetiously. Overall, a rate increase is extremely unlikely.
  2. Rates Unchanged: This is the most likely outcome with the best short-term risk/reward structure, at least in the Fed's eyes. Nothing changes, lending is muted and inflation continues to bleed into the economy at a moderate rate. I expect rates to be unchanged, but accompanied by a somewhat hawkish tone to counter a re-deployment of QE and the inflation expectations that will follow.
  3. Rate Decrease: The Fed can't lower rates any further, hence QE.
Scenario 1: QE2 Ends on Schedule - No more QE?
In this scenario the appetite for treasuries will wane and rates will be forced to increase, essentially countering any low rate policy. Eventually this will begin to affect the greater economy, produce a slowdown, and possibly push the US back into recession (at least officially). This, however, is a catch-22 situation. If rates increase the debt levels will also increase as a result of an economic slowdown, which would result in a reduction of gross receipts, an increased deficit, more debt issuance, and of course some entity would be required to buy the new and mounting debt. That entity would likely be the  Fed, and guess what that means...more QE. To recap, the cessation of QE2 makes QE3 certain. With that said, there can be a time lapse between the two programs and that's really the only question.

Now for the caveat. A crisis causing a flight to the dollar (war/terrorism) or a game changing technology have the ability to boost treasury demand (for the former) or produce organic growth (for the latter). The crisis card has been played before, but its effectiveness has significantly deteriorated over the years and any crisis would likely support gold rather than the dollar. In addition, a flight to the dollar would only be a temporary phenomenon without underlying fundamentals supporting it. This is where organic growth would have to take hold by way of a game-changing technological innovation that can be brought to market rapidly. Unfortunately this doesn't look likely with the state of the economy and no technology that fits the bill.

Overall, ceasing QE2 guarantees QE3, barring organic growth brought on by game-changing technology and economic restructuring. With that said, there may be a time lapse between the two programs.

Scenario 2: QE2 Ends, QE3 Begins...QE to Infinity
If QE3 is initiated completely above-board and immediately following QE2 there is a real risk of stoking runaway inflation expectations. This would be met by a loss of confidence in the dollar (at least what's left) and a widespread move into real assets, especially gold and silver. With that said, expectations can be managed to a degree by rhetoric, program size, and program duration. In addition, the exchanges have recently shown that they can and are willing to affect commodity prices by implementing margin increases and squeezing liquidity out of the futures market. Of course, the effect is always short-lived as the fundamentals inevitably catch up.

Overall, the Fed is expected to implement QE3. The parameters that they can play with are: program size, duration, timing, and name (call it something else). The Fed may also be willing to lean on exchanges to manage commodity prices.

Likely Scenarios: QE3 Lite or QE3 Late

Possible FOMC Statement #1 (Mostly Cut & Paste): 
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $XXX billion of longer-term Treasury securities, at a pace of about $XX billion per monthThe Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted. 
Synopsis: Rates are kept low, immediate program continuation and a small initial program with short-duration expectations.

Possible FOMC Statement #2:
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
As previously announced, the Federal Reserve’s purchases of $600 billion of Treasury securities will be completed by the end of June 2011The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the third quarter of 2011. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. 
Synopsis: Rates are kept low while the program winds-down with an option to continue later in year.

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