Now that we are in the year's second quarter, the end of the United States Federal Reserve's asset purchase program - dubbed quantitative easing two (QE2) - suddenly seems to be rushing toward us. The debate among market participants that remains unsettled is whether June 30<sup>th will in fact be the retirement of this form of monetary policy, or will it instead spawn an offspring for another period of time - QE3?
The Fed instituted its first round of quantitative easing - now known affectionately as QE1 - in late 2008. Then the Fed used its considerable balance sheet to purchase mortgage-backed securities in order to trim interest rates and lower mortgage rates to help the beleaguered housing market and cost of borrowing for businesses and consumer alike. That program did work to bring rates lower but did little to cure the ills of the housing market or negate the economic decline from lasting several more months. With the benefit of hindsight, the wounds imparted on consumers and businesses took more than lower interest rates to convalesce.
We do not see a renewal of the Fed's quantitative easing program as likely unless the economy suffers significant renewed weakness. The mission of QE2 was to reflate the economy and risk assets to stimulate inflation and consumption through an increased wealth effect. In that respect, QE2 has been effective. Equity markets, since the unofficial declaration of the Fed's intent in Jackson Hole, Wyoming in late August, have rallied sharply. In addition, consumer prices have stopped declining and begun to move sequentially higher. And employment gains are being reported regularly, an important factor in insuring the durability of the economic expansion as the Fed begins to withdraw its unconventional policy. Interest rates, on the other hand, have moved higher since the Fed's "official" announcement of QE2 in early November bringing some to question the success of the Fed's exercise. In all though, the underpinnings to support the need for further artificial stimulation are mostly absent.
While the U.S. economy has averaged a decent if unspectacular real GDP growth rate of 3% in the past six quarters, a sustained expansion appears to be well underway and deflation risks have mostly evaporated. That should give the Fed reason to pause if not vocally dispel any need to have a QE3. There are other reasons to believe a QE3 is a remote possibility, however. They include the size of bank reserves which are plentiful to assist in stimulating activity, the political disdain for more monetary intervention, and even the Fed's own internal strife over the need for even completing QE2 let alone a new program of quantitative easing.
A question that looms as the end of QE2 nears is how the bond vigilantes might react. Fears of a jump in bond yields are probably overdone, but we do expect some pressure on bond prices to in the offing. Not only are there building concerns about inflation, but the void left by the majority buyer of Treasury Bonds may be hard to fill without investors demanding a higher return. There, is of course and not necessarily bad, the possibility that the market may view the removal of the Fed as a buyer positively, treating it as a sign of economic stability and almost de facto tightening if maturing bonds are allowed to run off without replacement.
In either case, U.S. government bonds are unattractive since the yields today offered to investors are appealing only if the Fed cannot engender economic growth. That seems to us to be a low probability wager. As we have seen so far, the Fed isn't shy about firing up the printing presses and we suspect would do so again to preclude that scenario from happening.