A Pros And Cons Analysis Of QE3

From Peter Tchir of TF Market Advisors

To QE or not to QE, that is the question.

So here is what I expect to happen and why. 

The Fed will continue to re-invest proceeds from repayments. 

The Fed will use proceeds from pre-payments and redemptions to buy new assets.  If they don’t purchase new assets, they are effectively tightening.  Any time one of their treasuries matures, they will receive payment from the treasury.  This money has to be reinvested or else the Fed will have to remove some 1’s and 0’s from somewhere in the system, effectively, unprinting money.  So using the proceeds merely keeps the status quo. 
As part of this, they will also announce that they tend to purchase longer dated assets with these redemption proceeds.  They will argue that they want to add additional support to the long end of the curve specifically to help the mortgage market.  They may even go back to purchasing mortgages and not just treasuries.  The rationale of using the money to lend as much support to the mortgage market as possible is the most politically acceptable reason.  An unspoken reason for extending maturities will be growing concern within the Fed that this tool will be taken away, so to ensure the most control of their balance sheet they will want to extend their portfolio and reduce roll off going forward.

I believe the market has almost completely priced this in.  Any sign that they will not re-invest proceeds would be a negative for the market.  I’m not sure the market is pricing in any extension out the curve or into mortgages so those could provide mild upside.  I’m a little concerned that much of what I read and hear tends to view re-investment as a continuation of QE2.  I don’t see it that way.  Any re-investment of proceeds from a treasury redemption is merely keeping the status quo.  No new money is being created nor being pumped into the system, its no different than if the Fed had originally purchased this longer dated bond. 

QE3 will differ from QE2 and has only a 50/50 probability of being announced

On a basic level, the hawks within the Fed would like to pause the QE program at the end of June.  The doves are far more likely to be pushing for another round, but they seem less aggressive right now.  The economic data is much stronger than when QE2 was first announced, although it has been weakening of late, and the sovereign debt crisis in Europe has taken another leg down.  In an ideal world for the Fed, they would allow QE2 expire in June, but talk up the potential for QE3 in the event it is needed.  There are two problems with this approach.  One problem is that the Fed is well aware of the growing criticism of the policy.  Somewhere in the back of his mind, Ben, must be concerned that if he does not proceed with QE2 now, there will be too much pressure on the voting members to launch QE3 later.  If they don’t launch QE3 in June but the data deteriorates to the point they want to launch in September, the outcry might just be too strong.  The government as a whole is already against it.  Certainly the argument that ‘it worked’ would be difficult to make, the reality would be that just like so many other programs is that it increased current economic activity at the expense of future economic activity.  Also, since Ben is constantly trying to manage expectations, what would the market reaction be to a Fed that does not proceed with QE3 in June but tries to do it only a short while later?

So I think they might be pressured into launching a version of QE3 in June, but I think it will look very different from QE2.  I expect that it would target longer dated treasuries and possibly even mortgages, in an effort to create the most political support.  I also believe it will be more open ended.  Rather than saying we will spend $X billion in 6 months and here is our purchase schedule and target portfolio, he will create a ‘war chest’. QE3 will be positioned as we have $X billion that we are prepared to use to purchase longer dated treasuries and mortgages if and when we see the need to add support.  This would be a true compromise.  It does not force the Fed to create a schedule of auctions like QE2, in fact if the data remains stable they don’t have to do anything.  That should appease the hawks.  By targeting maturities that directly impact mortgage rates, its more palatable to the average American, and by keeping the activity less obvious they can deflect any links to inflation more easily.  It also keeps the purchases open at a time when there must be some real concern that this alternative tool could be restricted in the future.

I believe that the market is set up for some disappointment.  It feels like a lot of investors are saying they don’t expect QE3 but deep down think it’s likely and are positioned for the positive surprise.  Another group of investors seems convinced that no QE3 is priced in so are comfortable being long since only a positive surprise could happen.  In the end, I think a full QE3 announcement is mildly positive, a version of QE3 lite as described above is a minor negative, and no QE3 would be negative for the markets.

What the interested parties are pushing for

Ultimately Ben and the board will determine whether to pursue QE3 based on its merits, but there are a lot of interested parties that are pushing their agenda and likely have some influence on the outcome.  In the end, for all these reasons, believe that it is only 50% chance that QE3 is implemented, and if it is implemented it will have more flexibility than QE2 and a more concentrated effort to help mortgage rates.

Wall Street is for QE3

The QE program is great for Wall Street.  They will want to see it continue.  At the most basic level, the treasury is purchasing about $120 billion a month in treasuries from them.  If the street is making 1/8 on each trade with the government, that is $150 million of profit for the street every month.  For a product like treasuries, maybe an 1/8 is too much, but since the Fed doesn’t disclose the purchase price, just the quantity, it’s not a horrible assumption.  Asides from the direct bid/offer income made from the sale, the Fed is a dream client.  They are big, and tell you what they want to do.  If the street isn’t able to scrape out another 1/8 or 1/4, I would be surprised.  So I think we can assume that the treasury desks make another $200 million a month from trading ahead of the POMO schedule.  That is over $1 billion of additional profits for the street every quarter.  That is hard to give up.  From the earnings announcements so far, most of Wall street had strong revenues in their fixed income departments.  A part was certainly coming from corporate new issues, but with secondary volumes light across the board in corporates, it makes sense that a portion of that performance came from treasury trading related to QE2.

That $1 billion a quarter is just an estimate of the direct impact for the banks.  The extra $300 billion a quarter in money the Fed is printing has helped increase asset values and likely enhanced trading revenues on other desks as the money had to go somewhere.

So Wall Street would certainly prefer to see a QE3.  They would never tell the Fed these are the reasons, but its certainly in their interest to push for more QE.

New York Fed is for QE3

I am going to treat the New York Fed separately from the other Fed members.  First, their district benefits the most from QE.  Keeping Wall Street happy is particularly important for the New York Fed.  But I also believe that they like buying $120 billion of treasuries every month.  They are an important player in the market.  Wall Street traders who make multiples of what they do are finally at their beck and call.  Maybe its all subconscious but its hard not to believe that Dudley enjoys having Wall Street ‘need’ him.  The New York Fed gains prestige and the employees enjoy the power of wielding so much money, so they have a strong bias to maintain POMO.  They won’t say it, but buying bonds and dealing with the street all day, is a lot more fun than writing two year plans that no one will ever read or follow.

The Average American is against QE3

The average American cares about jobs, mortgage rates, and how much it costs to make it through a day.  The ‘success’ of QE2 has always mystified them.  They heard about job creation but never really knew anyone who got a job from QE2.  They heard it helped mortgage rates, but most had already refinanced, or are so underwater it doesn’t matter, so they assumed it must be working.  They have some stocks in their 401k, so that’s been good, but their company is threatening their pensions which is what they were really relying on anyways.  Nothing they heard about QE2 seemed to match what they were experiencing, but they let it go.  Suddenly the cost of making it through the day has been sky rocketing.  Their paycheck is the same, but gas, coffee, and food are all getting more expensive.  They are nervous about the prices they are paying for things and are starting to blame this QE thing for it.  They are also doubting it really did any of the good things people said it did.  This message is becoming louder and congress is hearing it loud and clear. 

Foreign Governments are against QE3

Regardless of what Ben says, other countries see QE as inflationary.  Regardless of Obama’s contention that speculators are pushing up the price of oil (in dollars) other countries see the QE policy as partly responsible.  China and other countries closely tied to the dollar as seeing inflation as a result and are not happy.  The U.S. is also not the only country experiencing minimal growth.  Other countries are too and the devaluation of the dollar is not helping their recovery.  Even strong countries like Germany must occasionally look up from the task of bailing out the PIGS and wonder what the consequences of a strong Euro will have on their economy down the road.  We have annoyed the world before, but usually we do that when we feel that we have the moral high ground.  With QE, I’m not sure that anyone can really hold their head high and argue with foreign governments that what we are doing isn’t short sighted and selfish.  This would be less of a concern if we didn’t need them to buy our debt and weren’t hoping that they won’t retaliate on the trade front.

Corporations are mixed on QE3

The impact to corporations has been mixed. 

The immediate impact to any company with overseas income has been positive as they translate those earnings back into weak dollars.  This is good so far, but may be temporary as other countries implement policies to fight the weak dollar.

Those that can sell overseas are benefitting from the weakness in the dollar as their products are more competitive.  The commodity companies are benefitting directly as prices of their selling prices spike.  Companies that have relatively low costs of input (technology) are also doing well; whereas, some manufacturing companies with intensive raw material usage are seeing pressure on margins in spite of increased opportunities overseas. 

So in general, corporations are slightly positive on QE as beneficiaries of the weak dollar but are growing concerned as they see margin pressure building.

The Fed is pro QE3

The Fed still feels like it is leaning towards QE3 but is being held back by fear of backlash from the average American, government, and foreign pressure.  Maybe they are even a little afraid they have unleashed inflation in spite of their denials that QE2 could in any way cause inflation – it merely caused the expectation of inflation which reduced the risk of deflation and made the whole world better.  If they knew for certain that they would be able to launch QE3 anytime they wanted to, they would definitely hold off, but I think they feel it would be prudent to put QE3 in place right now, even if on a limited basis, rather than having to restart the program – which could be very unpopular, and may cause us more harm then good if that flip-flopping behavior spooked the markets.