As QE2 ends, market debates Fed's next move

Thu Jun 30, 2011 12:00am EDT

  
 * QE2 prevented deflation, but growth still sluggish
 * With economy struggling, investors debate odds of QE3
 * Threshold for Fed to act again higher this time
 By Steven C. Johnson
 NEW YORK, June 30 (Reuters) - The Federal Reserve ends its
$600 billion bond-buying program, known as QE2, on Thursday and
has yet to offer any hints of more monetary easing to come.
 That hasn't stopped investors from wondering what new
tricks the central bank may have in its repertoire should the
U.S. economy's struggles continue in the second half of 2011.
 Bill Gross, manager of PIMCO, the world's largest bond
fund, said last week the Fed may signal as soon as August that
it stands ready to print more money if the economy worsens and
recession starts looking like a real possibility.
 "I'm surprised at how quickly talk has turned to QE3. It
began even before QE2 had ended," said Gregory Whiteley, who
manages the government debt portfolio at DoubleLine Capital, a
Los Angeles-based fund with some $12 billion in assets.
 "But it's a bit like automakers who offer incentives to
buy. People get hooked on them, and before one program ends,
they're thinking about when the next one will come along."
 Not everyone thinks the Fed will act quite so quickly.
Including QE2, the central bank's unprecedented policies in
recent years have pumped $2.3 trillion into the financial
system.
 After a recent run of weak economic data, Fed chief Ben
Bernanke said last week that "a little bit of time to see what
happens would be useful" before taking more policy decisions.
 In a Reuters poll of 24 fixed income strategists this
month, the median probability of QE3 was 20 percent. A poll of
46 economists in May had even longer odds of 15 percent.
 But timing for the Fed has not been ideal. The end of QE2
comes just as the U.S. economy is losing steam. Growth slowed
sharply in the first quarter and data has yet to signal a quick
recovery. The jobless rate remains above 9 percent.
 "Part of the Fed's mandate is to support full employment,
so they will have to stay involved," said Quincy Krosby,
investment strategist at Prudential Financial, with $859
billion in assets. "They will have to get more imaginative."
 GRADING QE2
 How the Fed would do that depends largely on whether one
thinks QE2 and all its side effects were worth the trouble.
 The policy was launched late last year to keep a fragile
U.S. economy that had just endured the worst recession since
World War II from falling back into recession.
 The risks at the time were real. Recovery had stalled,
prices were falling, the jobless rate was rising and stocks had
gone into a multi-month swoon.  
 "QE2 was an extraordinary policy tool designed to stave off
deflation and it has clearly worked," said Alan Wilde, who
helps manage $50 billion at Baring Asset Management in London.
 "I'm surprised central bankers have not tried to take more
credit for getting some inflation back into the system. They
should be shouting this from the rooftops."
 But while all that cheap money sparked a stock market rally
-- the benchmark S&P 500 is up some 25 percent since Aug. 26,
2010, the day before Bernanke hinted QE2 was coming -- it also
helped boost oil prices, which hurt consumers and did little to
encourage job growth or revive a moribund housing market.
 It weakened the dollar, which makes U.S. exports cheaper
and theoretically helps growth. But that has stoked inflation
abroad and, some say, threatens to raise U.S. prices as well.
 Greg Michalowski, chief currency analyst at FXDD, said the
mixed results may make the Fed think twice about another
round.
 "I think maybe one of the reasons why they're not doing QE3
is because, well, you know, (QE2) didn't work." he said. "Oil
prices went up. Money went into speculative things. It (hasn't)
gone to lending. It's going to speculation."
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 'NUCLEAR OPTION'
 Wilde said he thinks "QE3 is still a long shot," but added
that persistent below-trend growth or rising unemployment mean
"a further round (of easing) cannot be ruled out completely."
 One method could be what BofA-Merrill Lynch economist Ethan
Harris terms "the nuclear option:" buying enough Treasuries to
cap yields at a certain level to stoke growth.
 The idea seems extreme but has garnered attention. Gross
said last week that the Fed could do this by purchasing as many
two- or three-year Treasuries as it takes to cap rates.
 Back in 2002, before he was Fed chairman, Bernanke also
staked out that ground, saying a Fed facing deflation could
announce explicit ceilings for Treasury yields.[ID:nN15279103]
 Harris said this could prove more effective than QE2
because it would amount to an open-ended commitment to buy as
many Treasuries as it takes to cap yields.
 "I do think they have ammunition left," he said. "If we
start to slide quickly toward recession and the unemployment
rate steadily goes up, they can act."
 But DoubleLine's Whiteley said speculators would challenge
and ultimately break the Fed's resolve. "It's like trying to
defend a currency -- market forces push it to the limit and the
central bank often relents."
 He also said yields could fall anyway once the Fed ends QE2
and private buyers pick up the slack. With growth slow, he said
the 10-year yield at 2.50 percent is not inconceivable.
 STRONG GROWTH CURES ALL
 Of course, if the economy regains its footing, talk of QE3
will fade just as quickly, analysts say.
 For one thing, higher inflation may tie the Fed's hands.
Core consumer prices, which strip out food and energy, rose 1.5
percent in the year to May. That's not alarmingly high but it
is near 2 percent, the top of the Fed comfort zone, and well
above a frighteningly low 0.6 percent in October.
 What's more, the Fed will likely remain the biggest
Treasury buyer as it reinvests principal payments from the
government and mortgage debt it owns.
 More than $110 billion of Treasuries held on the Fed's
balance sheet are set to mature in the next 12 months, and
analysts predict it could reinvest up to $190 billion from
maturing mortgage-backed bonds over that time. With deflation
no longer a clear and present danger, that may be enough.
[ID:nSGE75C001]
 Political opposition to more easing is also running high.
 To get around that, Prudential's Krosby said the move last
week by industrialized countries to release 60 million barrels
of oil from emergency reserves may have been a QE3 substitute:
an alternative way to take pressure off consumers and small
businesses and jump-start growth.
 After nearing $115 a barrel in May, a 2-1/2-year high, oil
slipped to around $95 this week CLc1.
 BofA-Merrill Lynch expects the S&P 500 to do just fine
without QE2. The bank's official year-end target is 1,400, but
head equity strategist David Bianco expects strong earnings
could push it as high as 1,500. .SPX
 Even if it falls short, Harris said, the Fed will
disappoint those investors who expect the central bank to rush
in immediately and protect them from big losses.
 "People may think there's a 'Bernanke put' out there," he
said, referring to the put options used by traders to protect
against price declines. "But they are not going to like the
strike price."
 (Additional reporting by Burton Frierson; editing by Dan
Grebler)






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