Well I have to admit I got that one wrong! Whilst I always knew that further QE would come, I didn’t think it was justified today. The Fed Chairman must be taking an even more negative view on the US economy that even me.
The justification for additional monetary easing was never there from a “price stability” standpoint but the FOMC have been swayed by its Chairman’s second focus on its second mandate that is “full employment”. In his press conference , the Fed’s Chairman Bernanke clarified his thinking on the need to reduce the unemployment rate. He clearly stated that he believes that by keeping US Interest rates low, and that means all US Interest rates all the way out to 30yrs, in the end US employment will start to improve. The Chairman believes that the US economy cannot stand on its own and requires further monetary easing and the Fed’s own forecasts are now suggesting that for the foreseeable future the US economy will not be able to grow without continual stimulus from the monetary authority. So for starters, the next 2 months at least, the Fed will purchase additional Mortgage Backed Securities, at a pace of $40bln per month. The purchases will start tomorrow. In addition to “Operation Twist” it means that the Fed will buy approximately $85bln in long dated securities per month. The Chairman, in his press conference, went on to say that the Fed would continue to buy long dated bonds to keep rates low for long, until the Unemployment rate returned to its long-term trend rate, assumed by most to be around 6%. That means years of asset purchases. The purchase program of MBS is equivalent to around a third of the current monthly new supply. “Operation Twist” will negate all the issuance of 10yr and 30yr US Treasuries over the next 2 months. So buyers of long dated securities will be fighting the Fed to get their hands on any.
By announcing purchases of just MBS at the moment, the Chairman has avoided the political accusation that he is monetising the Government debt and when asked if he was aware of what the response would be from the Republican party, the Chairman reiterated the view that the FOMC is not political. It obviously is, otherwise it wouldn’t have done such a careful bit of sidestepping the likely criticism. But Bernanke made it clear that when “Operation Twist” expires at the end of the year the Fed will certainly start purchasing long dated treasuries outright.
So what to the market reaction.
Initially, prices of 10yr to 30yr US Treasuries fell, with 30yr yields hitting 3%!. The front-end was better supported with confirmation that most FOMC members now believe there is no chance of any change in the zero rate policy for the next 3 years near enough. So 5yr and in yields fell. The bigger moves were in the MBS market where yields fell on 30yr MBS by around 12bp. This fall in yield increases the duration and led to selling of US Treasuries. This has for the meantime depressed 30yr US Treasuries. However tomorrow the Fed will begin purchasing MBS, as the purchases are made the dealers will unwind the shorts in US Treasuries and the yields on 30yr bonds are set to bounce back to lower levels.
The prospect of open ended purchases of long dated MBS and Treasuries by Fed, they cannot buy anything else, must lead to significantly lower yields on US Treasuries. Maybe to Japan style levels. Bernanke, an expert on Japanese monetary policy failings, left no one in any doubt that he will keep buying bonds until the unemployment rate falls to the long term trend rate. The fight will be is iff this level of unemployment has become more structural than just a temporary phase. Some argue that unemployment rates will remain at current levels for longer than historical models would suggest. Certainly the prospective governments of whoever ends up running the US after the elections have little in credible plans to address any structural unemployment problems.
The consequence of this open ended bond purchase program no-one can be sure of. So not surprisingly, interest rate implied volatilities rose. This actually makes Mortgages more expensive. I would as a consequence of QE3 expect to see US Interest Rate Implied Volatilities now rise even further from the current elevated levels even if historical levels fall. One important thing is that the market will be even more focused on the monthly, and even weekly, employment data to try and sense when the Fed could end its asset purchase program. That of course is actually years away but traders will focus on the forward curve now. It will mean a significant rise in volatility of long dated fixed income assets. We are seeing that this evening with 10yr IRS implied volatilities rising whilst short dated 5yr IRS Implied Volatility falling slightly. So the Fed’s target of reducing the cost of mortgages may fail.
Other asset classes have seen sharp rises in prices. And even here Bernanke in his press conference alluded to the fact that he is looking for rises in equities and house prices to give the consumer a lift and help the US economy. So for once he is being a little bit more honest and saying that asset price inflation is indeed now something the Fed are actually targeting. So the target is for all assets to rise, the question is whether this is actually obtainable when it is obviously clear that the US Central Bank expects a poor economy in the coming years. An economy that cannot be self sustaining. So where will the real wealth generation occur outside of Wall Street who will use the Fed’s purchase program to be a backstop on Fixed Income Asset Prices.
A fall in 10yr US Treasury yields would raise the valuation of US company future earnings, but those earnings have to be in more doubt now given the Fed’s assessment of the future trajectory of the US economy and especially the demand side of the economy. So a rise in 10yr Interest rate volatility is a clear sign that equities should be falling in price not rising. And similarly other asset classes that rely on wealth generation. I always here the mantra, “Don’t fight the Fed” and for once I am agreeing with that. Why buy anything other than what the Fed are buying, MBS and US Treasuries. There is less risk there!