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The QE2 trade is now officially over

The Fed could announce a federal funds target of 3% but the tsunami of excess reserves now out there swamps any conceivable demand, so the Fed funds rate would be guaranteed to remain stuck at zero. The target would be meaningless.

-Ryan Avent as quoted in Why the Federal Reserve wants to drain excess reserves, Dec 2009

This is the problem for the US Federal Reserve. And now that people are talking seriously about exit strategies for the Fed, it makes sense to discuss these mechanics. Yes, I know some people are still talking about QE3, but let’s deal with that if and when the economy swoons after QE2 is over.

What got me to thinking about this was a Bloomberg article about James "Seven Faces of The Peril" Bullard. Remember, Bullard is the Fed official which got us started on the road to QE2 when he said:

Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.

When Bullard said those words, everyone knew the Fed was going to start buying up Treasuries. So, Bullard’s most recent statements bear remembering. These are very important words.

If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we’re going to start withdrawing our stimulus, and I’d start by pulling up a little bit short on the QE2 program.

Can we start dumping risk assets now? Seriously. The QE2 trade is now officially over. Remember guys like David Tepper telling us last September that they were going to run with the Bernanke put? Well now there’s the Bullard call instead of the Bernanke put. Bullard is telling us the jig is up. QE2 is finished.

Here’s the part I want to highlight though. The Bloomberg piece reads:

If the Fed opts to start withdrawing stimulus and tighten policy, it should start with the “balance sheet” by selling bonds first, then changing its wording about keeping interest rates near zero for an “extended period” and then raising interest rates, Bullard said.

If you go back to the Ryan Avent quote you will know why that’s the sequence of events. There’s no way the Fed can tighten with trillions of dollars of excess reserves in the system unless it raises the interest it pays on reserves in concert with its rate hikes. That’s a lot of interest payments. The Fed doesn’t want to make those payments. It would prefer to drain the excess reserves first and then start hiking rates later. That tells me that the fed funds rate will be effectively zero for some time to come.

So, the Fed has basically just announced it will stop QE2. It will then start selling Treasuries. And remember, this is at the same time the Treasury is selling $10 billion a month in mortgage securities. Only after this will rates be hiked. That doesn’t sound like a bullish scenario for risk assets. Could bond yields fall even though the Fed is selling if the economy swoons as a consequence?

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

13 Comments

  1. anjon roy says:

    Ed – Thanks for the great post, as always. Read your stuff on Naked Cap for a long time.

    Let me see if I got this: Fed will stop QE2 > start selling Treas > Keeping rates low of a long time.

    Couldn’t that last bit (sustained low rates) be good for risk assets, or at least keep a floor for them?
    Also, if the fed starts dumping many treasuries, economy swoons, bonds rally >>>> wouldn’t the fed pull back from it’s “exit” at that point? The whole purpose of QE/QE2 was to prevent a swoon.

    • Anjon,

      Thanks for reading!

      That last bit didn’t put a floor on risk assets during the panic obviously. And that’s what the Fed is worried about – that and the associated debt deflation. So they will want to see their ending QE2 not precipitating some sort of economic weakness that leads to a recession. If the U.S. did get another recession, then risk assets would not have a floor.

      • anjon roy says:

        Thanks Ed

        Well, during the panic, the risk assets crashed because of the run on the entire shadow banking system, or at least induced by the run, which was in-turn sparked by the Lehman failure (though the run had probably started as a trickle about a year before Lehman).

        Quick question, I’m assuming that the “end of Q2″ is not the same as “an exit from the extraordinary policies” – the later of which involves selling securities and draining the excess reserves. Do I have this correct?

        I guess it will be interesting to see what an end to QE2 will bring, especially if it is coupled with an “exit” (ie Fed selling it’s securities and reducing the size of the balance sheet). I guess it is possible that this could put the economy back into a debt-deflation/recession, which in-turn see risk assets drop in price. OTOH, if QE2 had limited positive spillover effects into the “real” economy, than is it possible that an exit from QE2 will similarly have limited negative spillovers? Furthermore, if QE2 has been an” asset-price inflation pumping tool”, than it is possible that we could see asset prices drop hard, with the spillovers into the “real” economy limited to whatever comes from a “negative wealth-effect”.

        Would love to hear your thoughts on these various scenarios (assuming you’ve got time)

        I sure wish I had discovered your blog earlier instead of just reading your guest posts on Naked Cap and RGE (back when I had access). Really liked you material on Corporatism, Stim, mal-investment, etc

        I get the impression you’re a Minsky guy

        • Did you read what Marc Chandler wrote about Bullard? I would agree with him that the Fed will not want to make a hasty exit from QE2. I think they will see it out through June and then pause. At some juncture after that, if the economy is OK, they will start to sell Treasuries. The timetable depends entirely on the economy of course.

          Minsky is great. I also like Kindelberger on bubbles and crashes.

  2. anjon roy says:

    Ed – Thanks for the great post, as always. Read your stuff on Naked Cap for a long time.

    Let me see if I got this: Fed will stop QE2 > start selling Treas > Keeping rates low of a long time.

    Couldn’t that last bit (sustained low rates) be good for risk assets, or at least keep a floor for them?
    Also, if the fed starts dumping many treasuries, economy swoons, bonds rally >>>> wouldn’t the fed pull back from it’s “exit” at that point? The whole purpose of QE/QE2 was to prevent a swoon.

    • Anjon,

      Thanks for reading!

      That last bit didn’t put a floor on risk assets during the panic obviously. And that’s what the Fed is worried about – that and the associated debt deflation. So they will want to see their ending QE2 not precipitating some sort of economic weakness that leads to a recession. If the U.S. did get another recession, then risk assets would not have a floor.

      • anjon roy says:

        Thanks Ed

        Well, during the panic, the risk assets crashed because of the run on the entire shadow banking system, or at least induced by the run, which was in-turn sparked by the Lehman failure (though the run had probably started as a trickle about a year before Lehman).

        Quick question, I’m assuming that the “end of Q2″ is not the same as “an exit from the extraordinary policies” – the later of which involves selling securities and draining the excess reserves. Do I have this correct?

        I guess it will be interesting to see what an end to QE2 will bring, especially if it is coupled with an “exit” (ie Fed selling it’s securities and reducing the size of the balance sheet). I guess it is possible that this could put the economy back into a debt-deflation/recession, which in-turn see risk assets drop in price. OTOH, if QE2 had limited positive spillover effects into the “real” economy, than is it possible that an exit from QE2 will similarly have limited negative spillovers? Furthermore, if QE2 has been an” asset-price inflation pumping tool”, than it is possible that we could see asset prices drop hard, with the spillovers into the “real” economy limited to whatever comes from a “negative wealth-effect”.

        Would love to hear your thoughts on these various scenarios (assuming you’ve got time)

        I sure wish I had discovered your blog earlier instead of just reading your guest posts on Naked Cap and RGE (back when I had access). Really liked you material on Corporatism, Stim, mal-investment, etc

        I get the impression you’re a Minsky guy

        • Did you read what Marc Chandler wrote about Bullard? I would agree with him that the Fed will not want to make a hasty exit from QE2. I think they will see it out through June and then pause. At some juncture after that, if the economy is OK, they will start to sell Treasuries. The timetable depends entirely on the economy of course.

          Minsky is great. I also like Kindelberger on bubbles and crashes.

  3. gregor.us says:

    Well, if QE is over then the FED in conjunction with the government has made a decision to let housing fall to its natural level. I find that hard to believe, but let’s acknowledge that housing is already crashing again. Interest rate rises on top could produce a 20% YOY decline, therefore, in some markets.

    When I say interest rate rises of course I mean not by the FED, but by the market.

    As important, the 5 year revisions to California’s jobs situation show that a new, lower low was made in total employment nearly one year after the pre-revised low. November and December 2010 saw new lows in total employment, which is to say there has been no improvement at all in CA’s job market. Moreover, the growth in food stamp use remains strong.

    It’s very hard for me now to call the FED, as I have learned how much they don’t know. Years back, I thought they knew more–and they did–because that was a pre credit bubble burst era. Now, it’s clear they know less. So, they are liable to make even bigger mistakes.

    Fun times. :-)

    Gregor

    • When the Fed topped QE1, rates fell and the economy soured, prompting QE2. My sense from the totality of fed communications – from both hawks and doves – is that they will stick to their original timetable and then pause. At that point they have decide whether to mop up the excess reserves. If the economy is too fragile they will simply do nothing and wait. If the economy really sucks, the QE3 speculation can begin.

      Bottom line: we are a long way away from either QE3 or raising rates. Over the near term, it’s a question of what to do after QE2 is over.

    • Gregor, one more thing. Hawks like Bullard saying the Fed should cut QE2 short anchors the discussion. That’s significant. If Bullard is saying they should stop QE2, let alone not do QE3, that is going to get everyone talking about whether QE2 will meet an untimely demise. Personally, I think that’s the goal because it makes QE3 a non-starter right now.

      Basically the QE2 trade is officially over and people are now thinking about its end. In a sense, that’s a good thing because it can help determine how markets behave without QE as a backstop.

      • gregor.us says:

        I like your framing that Bullard’s chatter anchors the discussion. From my perspective, as one who has been much more bullish on asset reflation and much more bearish on the real economy–the past 18 months–I say: bring on the hawkish talk, the pause in QE, and even a bit of mopping up operations. This will only reveal more quickly the true state of things. And, while I’m open to a small array of counterintuitve results from such a pause–like maybe some homebuyers get off the sidelines causing some to say “see I told you so, easy money was the problem”–I still think a pause in QE will deliver us to QE 3. I’m feeling ghoulish. I’m just happy to have a front row seat to the show. :-)

        Seriously, though, I really don’t think the FED knows how to manage systemic descent. The paradigm on which they rely is expansionist, needs cheap energy, and requires lots of forward motion to aid in cleaning up mistakes and shifting into new directions. Current conditions don’t fit into their basic model: “provision of credit will always unfreeze the economy.”

        Cheers.

        G

        • Anjon Roy says:

          Great stuff gents.

          What do you see the departure of KC Fed Thomas Hoenig (spelling?) later this year. I understand he’s the biggest hawk of them all – perhaps along with Dallas Fed chief Fischer – and his long tenure perhaps gives him credibility. Does this change the debate inside the FOMC meetings?

          Seems to me like you guys think that low rates are here to stay for a long long time? Venture any guesses on that front? I assume we’re talking number of years…

          • Anjon, the centrists and doves are in control of the FOMC. Bullard is anchoring discussion but that won’t change Fed policy in my view. I do think rates will be low for an extended period. So I don’t see Hoenig’s departure as a big deal.

  4. gregor.us says:

    Well, if QE is over then the FED in conjunction with the government has made a decision to let housing fall to its natural level. I find that hard to believe, but let’s acknowledge that housing is already crashing again. Interest rate rises on top could produce a 20% YOY decline, therefore, in some markets.

    When I say interest rate rises of course I mean not by the FED, but by the market.

    As important, the 5 year revisions to California’s jobs situation show that a new, lower low was made in total employment nearly one year after the pre-revised low. November and December 2010 saw new lows in total employment, which is to say there has been no improvement at all in CA’s job market. Moreover, the growth in food stamp use remains strong.

    It’s very hard for me now to call the FED, as I have learned how much they don’t know. Years back, I thought they knew more–and they did–because that was a pre credit bubble burst era. Now, it’s clear they know less. So, they are liable to make even bigger mistakes.

    Fun times. :-)

    Gregor

    • When the Fed topped QE1, rates fell and the economy soured, prompting QE2. My sense from the totality of fed communications – from both hawks and doves – is that they will stick to their original timetable and then pause. At that point they have decide whether to mop up the excess reserves. If the economy is too fragile they will simply do nothing and wait. If the economy really sucks, the QE3 speculation can begin.

      Bottom line: we are a long way away from either QE3 or raising rates. Over the near term, it’s a question of what to do after QE2 is over.

    • Gregor, one more thing. Hawks like Bullard saying the Fed should cut QE2 short anchors the discussion. That’s significant. If Bullard is saying they should stop QE2, let alone not do QE3, that is going to get everyone talking about whether QE2 will meet an untimely demise. Personally, I think that’s the goal because it makes QE3 a non-starter right now.

      Basically the QE2 trade is officially over and people are now thinking about its end. In a sense, that’s a good thing because it can help determine how markets behave without QE as a backstop.

      • gregor.us says:

        I like your framing that Bullard’s chatter anchors the discussion. From my perspective, as one who has been much more bullish on asset reflation and much more bearish on the real economy–the past 18 months–I say: bring on the hawkish talk, the pause in QE, and even a bit of mopping up operations. This will only reveal more quickly the true state of things. And, while I’m open to a small array of counterintuitve results from such a pause–like maybe some homebuyers get off the sidelines causing some to say “see I told you so, easy money was the problem”–I still think a pause in QE will deliver us to QE 3. I’m feeling ghoulish. I’m just happy to have a front row seat to the show. :-)

        Seriously, though, I really don’t think the FED knows how to manage systemic descent. The paradigm on which they rely is expansionist, needs cheap energy, and requires lots of forward motion to aid in cleaning up mistakes and shifting into new directions. Current conditions don’t fit into their basic model: “provision of credit will always unfreeze the economy.”

        Cheers.

        G

        • Anjon Roy says:

          Great stuff gents.

          What do you see the departure of KC Fed Thomas Hoenig (spelling?) later this year. I understand he’s the biggest hawk of them all – perhaps along with Dallas Fed chief Fischer – and his long tenure perhaps gives him credibility. Does this change the debate inside the FOMC meetings?

          Seems to me like you guys think that low rates are here to stay for a long long time? Venture any guesses on that front? I assume we’re talking number of years…

          • Anjon, the centrists and doves are in control of the FOMC. Bullard is anchoring discussion but that won’t change Fed policy in my view. I do think rates will be low for an extended period. So I don’t see Hoenig’s departure as a big deal.

        • Anjon Roy says:

          Great stuff gents.

          What do you see the departure of KC Fed Thomas Hoenig (spelling?) later this year. I understand he’s the biggest hawk of them all – perhaps along with Dallas Fed chief Fischer – and his long tenure perhaps gives him credibility. Does this change the debate inside the FOMC meetings?

          Seems to me like you guys think that low rates are here to stay for a long long time? Venture any guesses on that front? I assume we’re talking number of years…

  5. takloo says:

    nice post outlining the possible sequence of events…

    some forecasters are expecting rate hikes towards the end of this year… how likely is that in your opinion given Ryan Avent’s quote?

    • Rate hikes in 2011 are unlikely. That would mean interest on reserves. Draining reserves is definitely first. And we don’t have to look any further than the BoE to see that even 4 or 5 percent headline inflation doesn’t spell rate hikes. I just don’t see it happening at this point.

  6. takloo says:

    nice post outlining the possible sequence of events…

    some forecasters are expecting rate hikes towards the end of this year… how likely is that in your opinion given Ryan Avent’s quote?

    • Rate hikes in 2011 are unlikely. That would mean interest on reserves. Draining reserves is definitely first. And we don’t have to look any further than the BoE to see that even 4 or 5 percent headline inflation doesn’t spell rate hikes. I just don’t see it happening at this point.

  7. anjon roy says:

    Do you see a possible de-coupling between the “real” and “financial assets” economy? Risk assets pull back, but the economy continues it’s cyclically-based slow pace improvement?

    It would be an inverse of the last 2 years where we’ve seen certain assets (equities, primary commodities, especially Silver) do quite well, even while the “real” economy suffered?

  8. anjon roy says:

    Do you see a possible de-coupling between the “real” and “financial assets” economy? Risk assets pull back, but the economy continues it’s cyclically-based slow pace improvement?

    It would be an inverse of the last 2 years where we’ve seen certain assets (equities, primary commodities, especially Silver) do quite well, even while the “real” economy suffered?