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1120ptest

Sunday, 19 Jun 2011 11:21 AM

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With today’s announcements from the Federal Reserve, two things are very clear: First, low interest rates are here to stay — at least for the foreseeable future. Second, the Fed has no plans yet to take steps to continue its Quantitative Easing program by greenlighting a third round.

Noting that unemployment remains stubbornly high and other indicators show a weak economy, the Fed reaffirmed today that it will keep the federal funds rate — currently at 0 to 0.25 percent — at historic lows “for an extended period.”

Fed Chair Ben Bernanke also made some key comments regarding the imminent end of the Fed’s bond-buying program this month, the aforementioned Quantitative Easing (QE), which involves the Fed buying government bonds as a method to increase the overall supply of U.S. dollars. Thus, the end of the program marked the first step towards tightening the money supply.

What’s the next step? The Fed has made it clear that proceeds from QE will be reinvested for now. In other words, monetary growth will slow to a crawl following its purchases of $75 billion per month for the past eight months.
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After this “wait and see” period of reinvesting, the Fed plans to gradually exit the large bond position it has established. Only after that process has run its course will interest rates become the key policy tool again, although it’s possible the Fed may start raising rates before they fully unwind that position.

Will the End of QE Derail Markets?

Since the start of QE, the increase in the Fed’s balance sheet has correlated strongly with rising stock prices. After the first round of QE ended in March 2010, stocks flattened and fell in the middle of 2010, before rising at an even faster rate once QE2 was announced in August 2010.

Story continues below chart

andrewfedjune22.jpg
Click to enlarge

Can we expect a similar situation today? So far, that seems to be playing out. Markets have been negative for the past several weeks ahead of the end of QE2.

Bill Gross, director of Pimco, made his position on QE clear back in March when he claimed, “It becomes a question of musical chairs to a certain extent: who gets out first and who’s the last one looking for a chair on June 30.” While Pimco has missed out on the most recent rally in Treasurys, he may be right over a longer timeframe. Gross expects no more QE programs.

QE to Infinity . . . and Beyond!

Negative data coming out in the past few weeks show the economy plunging into a recession again. This data includes poor jobs numbers (even ignoring those who are no longer considered unemployed because they’ve exhausted benefits or given up looking for work, as is the case with the most widely quoted government figure), slowing GDP numbers, poor production numbers, declining auto sales, and the dreaded “double dip” in housing prices.

If these numbers continue to trend negative, and markets correct substantially, there may be sufficient public support to justify another round of QE, or some differently named program with the same general intent, to prop up asset prices.

Some market participants and hedge fund managers believe this is inevitable. According to Lance Roberts of Streettalk Advisors, “Without another round of QE, and most likely soon, the economy will be headed for extremely low or potentially even negative growth.”

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