Goodbyes are never easy, and the end of quantitative easing is no exception. This is particularly true given how successful the Federal Reserve’s program has been at boosting investor confidence and driving up both equity and commodity prices.

But there remains much debate about whether the coming end to QE2 will be an easy separation, cause financial markets to stall, or perhaps unravel completely.

Eric Lascelles, chief economist at RBC Global Asset Management, points out that the Fed’s bond purchases in the first half of 2011 will have absorbed all of the net supply of Treasuries during that period. After the program expires, the rest of the world will need to purchase US$105-billion worth of net issuance in the first month just to keep pace with supply. In the second half of 2011, they will have to take down nearly a half a trillion dollars in Treasuries.

The end of QE2 also doesn’t exactly come at a great time in terms of investor psychology, Mr. Lascelles notes. The market is already concerned about peaking economic indicators and falling growth forecasts, while seasonal factors typically lead to weaker stock markets during the summer.

Meanwhile, the U.S. Treasury market faces the possibility that the Japanese will repatriate funds to finance post-earthquake reconstruction, at the same time as the United States faces a massive debt-load and political challenges impeding deficit reduction.

Nonetheless, Mr. Lascelles believes many of these fears are overdone and expects markets to suffer little more than a glancing blow as the Fed pulls back in the coming months.

Since financial markets are forward-looking, the economist says asset prices should already have factored in the end of stimulus. He also points out that the Fed is very aware of the effect its stimulus program has had on risk assets and is therefore reluctant to do anything that might threaten these gains.

Rather than dwell on the fact that the Fed will no longer be buying US$90-billion worth of bonds each month, Mr. Lascelles thinks it is more appropriate to focus on the fact that QE2 has increased the U.S. monetary base by US$600-billion and removed an equal amount of government bonds from the market.

“This doesn’t end in June – it peaks in June,” the economist says in a recent report. “Policy will be more stimulative in July than it is today. And the level of stimulus will remain at that peak for the foreseeable future, until the Fed elects to begin selling said bonds.”

History also appears to be on the Fed’s side as monetary policy inflection points usually only have a modest impact on markets. After all, the endorsement that the growth outlook is good enough to warrant a tug on the reins comes from a credible source. In fact, in the six months following an initial rate hike, U.S. equities usually rise about 5% and continue to climb for several years.

Despite the imminent loss of a major source of demand for U.S. Treasuries, supply and demand considerations usually take a back seat to other market drivers, Mr. Lascelles says. He suggests rate-sensitive buyers such as banks and individual investors could pick up the slack. So too may international investors seeking the safety of U.S. Treasuries given the financial crisis in Europe.

If the market were to collapse or if the economic recovery were to go off the rails in the absence of stimulus, the economist believes the Fed would have to seriously reconsider the end of quantitative easing.

“In other words, a QE3 could conceivably be conjured into being, despite the mounting risks from serial quantitative easing,” Mr. Lascelles says.

The Fed may not have the political capital to roll QE2 into QE3 today, but it will in the coming months, according to Douglas Borthwick, managing director at Stamford, Connecticut-based Faros Trading.

“The United States cannot afford a higher U.S. dollar that would halt gains in U.S. exports, and the United States cannot afford higher interest rates that would further complicate the housing market,” he said in a May 19 note to clients.

So whatever name is given to further quantitative easing, Mr. Borthwick believes its purpose will continue to be to limit U.S. interest rate increases and weaken the greenback. He says this will be the case until either the housing market recovers or the U.S. export engine drives the country forward.

The Bank of Japan has amassed a balance sheet that equates to roughly 30% of GDP and the U.S. Federal Reserve sits at about 18%

“As the last recipient of a lost decade, Japan has gone much further than the United States has currently,” Mr. Borthwick says, adding that the United States appears to be four years into a lost decade stemming from an overhang of debt distributed among a population that no longer earns or has savings enough to fund it.

“We believe that the United States will need to go as far as Japan if not further,” he says.

The Fed’s US$75-billion per month Treasury purchases has also been credited for the depreciation of the U.S. dollar since chairman Ben Bernanke first hinted at its possibility in August 2010.

“Given the way foreign exchange markets anticipate future flows and events, it is possible that the recent U.S. dollar rally is partially tied to the end of QE2,” says Greg Anderson, a currency strategist with Citigroup.

In fact, the beginning of QE2 was so well anticipated by financial markets that it marked the bottom of U.S. bond yields and economic factors seemed to take over afterwards in the rates market.

Mr. Anderson suspects something similar will happen now, only this time expectations appear to be ahead of the curve, instead of behind it.

The strategist believes that the end of QE2 will not be the end of U.S. dollar depreciation. He expects it will continue for the medium to long term, although at a slower pace in the near term than during both the lead-up and implementation of QE2.

Initially, the Fed will continue to reinvest interest and principal from mortgage-backed securities held in its portfolio, so its monthly Treasury purchases will fall from about US$90-billion per month to roughly US$15-billion. Since the overall size of the Fed’s portfolio is unlikely to change, there is no actual implied tightening of policy, Mr. Anderson says.

So just as the U.S. dollar starts to make headway, economic data such as housing starts, durable goods orders, first quarter GDP and jobless claims get worse. This underlines the message that while the official end of QE2 is coming, Fed easing shall remain in place.

Article provided via the Financial Post

http://business.financialpost.com/2011/05/27/say-goodbye-to-qe2-but-not-fed-easing/