The end of the Federal Reserve’s large scale asset purchase (LSAP), widely referred to as ‘QE2’ is a large and looming worry to investors. Despite the well-telegraphed end of the program, there are fears that there will be a destabilizing spike in yields, and investors are growing more cautious as the end of June approaches. Further complicating the issue is the recent price performance in US treasuries, which would appear counterintuitive.
Here we discuss our thoughts on the impact that the expiration of the program will have on the economy, treasuries and risk assets – and the implications for our strategy and portfolio positioning…..
Ed Fitzpatrick US Fixed Income di Schroders
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Impact on the economy
The Federal Reserve (Fed) has committed to keeping the stock of money stable (it will reinvest principal and interest and its balance sheet will not shrink). This is still a very accommodative monetary policy. However, the money supply is not increasing, so incremental stimulus has stopped. We believe this does make the economy more susceptible to exogenous shocks (such as Middle East issues, a Japanese tsunami or weather problems in the US).
With the conclusion of monetary policy stimulus in conjunction with some fiscal restraint in the second half of the year, the economy will be forced to stand on its own. However, we do not believe the pace of activity is strong enough to lead to a typical self-sustaining recovery. Although there have been some signs of underlying strength in the economy (manufacturing output and job growth), we expect growth will continue to disappoint and remain below traditional post-recovery levels. The US economy still remains mired in a long deleveraging process which will takes several years to normalize. Given the lackluster growth prospects, the Fed will likely maintain its zero interest rate policy for an extended period of time (probably longer than the market anticipates). This does not necessarily mean the US is headed for a double-dip recession, but rather a disappointing pace of economic activity. The increase in the money supply has served as a bit of a shock absorber for the economy, which is disappearing on the completion of QE2.
”This does not mean the US is headed for a double-dip recession, but rather a disappointing pace of economic activity.”
Impact on Treasuries
The Fed has been the largest purchaser of Treasury securities over the past six months. Our fair value model suggests that the size of the Fed’s holdings of treasury securities (~20% of the total marketable coupon debt outstanding) has resulted in a sizeable lowering of yields. This does not imply that the Fed’s exit from bond buying will result in an immediate increase in interest rates. Since the Fed will continue to reinvest coupon payments and maturities, the market will only need to absorb the incremental debt (less the principal and interest from the Fed’s mortgage portfolio reinvestment program). All market participants are aware of the final date of QE2 and should begin discounting the new supply/demand equilibrium prior to the expiration of the program. If yields do rise to reflect the exit of the Fed, it will most likely occur in June or shortly after the completion of the program.
Going forward, we believe rates will be dictated more by fundamentals (growth and inflation) and the behavior of risk assets once the Fed has officially ended QE2; a large sell-off in treasuries will not be predicated purely on the completion of the program. We expect the recent range in 10-year yields (3.00 -3.75%) to be unchanged after QE2, with more emphasis on the growth and inflation outlook as the key drivers when the range does break. Given the recent weakness in economic activity, and the fed funds rate at 0%, yields on treasuries should remain relatively well anchored.
Impact on risk assets
On the whole, the end of QE2 is likely to be less supportive of risk assets. It should be mildly supportive of the US dollar, all other factor being constant. To the extent that QE2 was responsible for an appreciation of equity and commodity prices, the completion of the program is likely to be negative for these asset classes (at the margin). This should be somewhat discounted in advance and may be partially responsible for the softening we are currently experiencing in those markets. The inflation outlook, particularly inflation expectations, remain well-anchored while growth remains below trend. This environment is conducive to an accommodative Fed, which should ultimately support risk assets. Corporate bonds in particular do well when growth and inflation remain below trend. The headwind to risk assets that the end of the program serves is the likely increase in volatility.
Outlook for QE3
Several Fed members have expressed concern over the effectiveness of QE2 and the extent to which the program encouraged some speculative investing in commodities and other risk products. Universally, the members have acknowledged a relatively high hurdle rate for incremental quantitative easing purchases. As Chairman Bernanke affirmed last week, “monetary policy cannot be a panacea.”1 In the absence of an exogenous shock which represents a systemic issue (EU sovereign/banking crisis, etc.) or a material and sustained retrenchment in private payroll gains, another quantitative easing program would appear unlikely. In addition, deflationary sentiment has effectively been removed from the market. The Fed’s favored measure of inflation expectations (5-year / 5-year Forward Break-Even Inflation Rate) is significantly higher than in 2008 or 2010 when the Fed enacted alternative monetary policy tools.
We also believe the Fed will wait for a correction in commodity prices after the criticism it has received from the global community over energy and food price increases. While the Fed may not draw a straight line between its actions and the price of commodities, it is cognizant of it. When asked if QE2 could be partially responsible for the increase in commodity prices, Dallas Federal Reserve President, Richard Fisher said, “I have argued that it could be partially responsible.”2
The political landscape is more difficult this year and the Fed risks further jeopardizing its independence if it engages in another round of quantitative easing that results in higher oil prices. We believe that, in the current economic and political landscape, the likelihood of QE3 remains rather remote.
There are a few signposts we are watching before increasing the probability of QE3:
1) 5/5-yr Forward BEIRs below 2.25%
2) Negative private payroll growth for 3 straight months
3) Equity sell-off greater than 15%
4) Oil prices below $85
5) A systemic shock
Portfolio positioning and strategy
There are more factors at play in the current environment than simply the expiration of the QE2 program. An economic soft patch has exacerbated the price action in risk assets at the time the QE2 program is ending. Risk assets are likely undergoing some form of correction associated with this soft patch which has resulted in desire to own treasuries. On the margin, one fewer purchaser (large) of treasuries is a negative. We believe this supply/demand equilibrium will be reflected before the completion of the program and the incremental impact will be smoothed out over several quarters. Given the uncertain economic backdrop and tighter liquidity (a less stimulative Fed) a neutral duration posture is appropriate at this time.
Over the longer-term we prefer to own assets that are currently deleveraging or are increasing leverage at a pace much slower than US treasuries. Most spread products (such as corporate bonds, MBS, CMBS) fit this profile. However, credit spreads are significantly tighter than two years ago (close to historical averages) but the incremental premium to compensate for increased volatility has declined (high yield bonds being the exception). We prefer to position the portfolio in securitized assets, particularly Agency MBS which are less sensitive to credit issues and economic volatility while still maintaining attractive spreads. Going forward there are still areas in the corporate bond sector that compensate investors for increased volatility and should perform well in our perceived low growth, low inflation environment. We would view a significant correction in credit in the coming weeks as a buying opportunity. As always, nimbleness will be a key tenant to our investment approach until we can determine the extent of the current economic soft patch.
The views and opinions contained herein are those of Azad Zangana, European economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.
Source: ETFWorld – Schroders