With the end of June in sight, so too is the end of the latest round of focused quantitative easing from the U.S. Federal Reserve commonly called "QE 2." Assuming that the program ends as planned, the Fed will have bought about $600 billion of various Treasury securities since late 2010, in addition to whatever agency debt proceeds were "re-invested" into Treasurys.
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To say that QE2 has been controversial is a massive understatement. For all of the angst and discussion of it, it is difficult to pinpoint exactly what it has, or has not, done and it is likewise difficult to predict what will happen in the aftermath of the program. That is the problem with monetary policy - it is one tool in a complex global ecosystem of inputs and influences. (For related reading, see Quantitative Easing: What's In A Name?)
Re-inflated Financial Markets May Lose Air
On first glance, it looks like the end of QE2 should be bad news for equity and commodity markets. Both have been quite strong since the announcement of QE2, and both stocks and commodities frequently outperform in low-rate environments. Particularly in the case of the stock market, QE2 has allowed once-troubled companies to roll over debt and issue stock in an effort to shore up balance sheets.
But the end of QE2 doesn't necessarily mean that stocks and commodities will be weak. While stocks and commodities have indeed done well since the announcement of QE2, they were also doing well before the announcement. Even allowing that some of that strength was from anticipation of a second round of easing, the fact remains that those markets were not strong during the first round of easing, so it is dangerous to make a one-to-one assessment of how markets will respond to easing.
One possible factor to watch is the more speculative corners of the market. There was little risk to borrowing during QE2 (and putting that money into the stock market or commodities) as it was clear that the Fed was not going to allow rates to go very high. With that guarantee off the table, there is the risk that some fast money will move on to new pastures. (For more, see Forces Behind Interest Rates.)
Rates Will Go Up … Or Not?
As the Federal Reserve has been busy buying up bonds, the assumption is that this has kept a lid on interest rates. Curiously, the 10-year Treasury rate was about 2.5% when QE2 started and sits at about 3% today after spiking up around February of this year. Certainly timing may have something to do with this; the Fed may have been especially active of late and that could be pushing down rates. But there are other facts in rates to consider.
Looking at major banks in the country like Citigroup (NYSE:C), Bank Of America (NYSE:BAC) and U.S. Bancorp (NYSE:USB), there is a notable absence of loan growth in recent quarters. The banks claim that low rates are not stimulating people to borrow, and that demand is low, though some skeptics argue that the demand is there and the banks are now too strict with their underwriting standards. Mortgage lending has not rebounded (and housing sales are weak), consumer spending seems pretty moderate, and most business either have ample cash already on the balance sheet or no immediate plans to expand.
It makes sense that the absence of Fed buying should move rates higher, but it is not necessarily true. The Bank of Japan has seen cases where its own easing programs were followed by lower rates and the same could happen here - interest rates reflect the price of money and if people do not need to buy money (take out loans) for productive purposes, there may not be as much rate pressure as some expect. (For related reading, see Taking Advantage Of Central Bank Interventions.)
Real Estate and Corporations - Much Ado About Something?
QE2 has not "fixed" the housing crisis, and it was never meant to do so. With the end of QE2, the housing market is still likely to remain weak. Unemployment is relatively high, wage growth has been non-existent, many would-be buyers have poor credit, and the public's notion of "housing as an investment" has seriously eroded. On top of that, the malfeasance of the banks has led to any number of problems in the foreclosure process and it is taking much longer to fix the mess. At this point, it looks like there just isn't much demand for housing, and that is likely to remain the case with or without QE2. (For more, see Why Housing Market Bubbles Pop.)
For companies, the end of QE2 is not likely to have a pronounced effect. Recent trends in rail traffic, business surveys, inventories and the like suggest that the economic recovery has slowed fairly significantly. How much of the recovery could be tied to QE2 in the first place is a matter of fierce debate, but the recovery started before QE2 and began to falter before its end.
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The large money center banks of the U.S. could be one of the relatively few industry groups to see a direct impact from this policy end. The Fed bought its securities from major parties like Citigroup, Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS) and did so in ways that clearly benefit these large banks. With the program set to end, it is not unreasonable to think that an implicit subsidy to these banks is also ending. That said, it looks like the bond market should be more volatile post-QE2 and volatility can be a very good thing for trading desks, so the sharper desks on Wall Street may mitigate a lot of that lost Fed business with more trading revenue.
No Easy Answers
Unfortunately, anyone who says that the end of QE2 means "rates are going to X" or "the S&P will go to Y" is just guessing. The reality is that monetary policy (and its impact) is complex and nobody ever really knows what happens when one string in the web is tugged in a certain direction or cut entirely. While higher interest rates, lower stock prices and lower commodity prices would seem to be logical conclusions, past experience around the world suggests that those predictions are tricky at best. (For related reading, see The Federal Reserve: Monetary Policy.)
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