An Earlier End To QE?

Via Scotiabank's Guy Haselmann,

Adieu, Sweet QE, Adieu

The FOMC should (and might) accelerate the pace of QE reductions to $15 billion on Wednesday (June 18th).  Furthermore, at its meeting on July 30th, the FOMC could – and should -announce a similar-sized reduction for the subsequent two months.   Hence, the Fed would not have to wait until its September 17th meeting to announce the final leg. QE would then end two months earlier at the end of August rather than the end of October as markets currently expect.  Such a path would generally afford the FOMC more freedoms, particularly at the September17th press conference meeting.

There are of plenty of reasons to justify such a move:  global interest rates are near historical lows levels; equity markets are at record high levels; the FTSE All-World index closing at an all-time high yesterday; the decade-low in volatility indices; the 6.3% Unemployment Rate; employment gains averaging 250K over the last two months; GDP forecasts for the remaining three quarters of 2014 fluctuating around 3% following the ‘transitory’ Q1 weather-induced slow down; the current lull (or temporary decline) in Ukrainian and Geo-political tensions; and lastly, the ECB accepting the stimulus baton.

Remember, FOMC guidance last year prophesied that QE was expected to come to an end when the unemployment rate hit 7% and the first hike would occur when the rate hit 6.5%.  In regards to this measurement, even the most dovish members have surprised themselves.

The Fed has indicated that it is “not of a pre-set course”.   There are advantages of keeping investors on their toes and having them believe that the FOMC is nimble and flexible.  In addition, it is likely that the Fed does not want to make the same mistakes made from 2004-2006 when it had become too predictable.

The Fed should accelerate the QE withdrawal not just because it is currently being provided with the economic, geo- political, and market cover to do so, but also because the risks to financial stability are intensifying with the rise in the size of its balance sheet. Central bank-induced moral hazard continues to motivate risk-seekers and fuel asset inflation. Even the uber-doves on the FOMC are beginning to discuss with greater frequency the potential risks from Fed policy and the ‘froth’ in financial markets.

One trouble with the FOMC trying to replace QE with forward guidance is that promises of future accommodation, implies that the economy will still be weak enough to require accommodative monetary conditions.  This perception saps market confidence.   Therefore, it is possible that ending QE sooner results in a boost to market confidence, as it might show more confidence in the FOMC’s outlook.  Personally, I do not think the market reaction will be this simple or binary, but will rather lead to an un-wind of the trades that have worked under QE.

Back in April, I wrote and explained why the Treasury market has almost become three different markets: the front end, the back end and the belly.  This will be abundantly clear if the FOMC decides to implement the plan above.  The front end would almost assuredly price in ‘earlier’ tightenings by the FOMC, while the back end will attempt to hold tight driven by concerns about a slip in future growth and inflation.   The curve would flatten materially.

I remain steadfast in my bullish view on long end Treasuries, as well as the belief that active traders can leg into and out of the front end shorts as Fed policy gets recalibrated.  Investors trying to set up for several ‘earlier’ interest rate hikes are likely to find some success, but I suspect the success will only be temporary, simply because the FOMC has no idea as to when the first rate hike is likely to occur.  Committee members are anxious to first witness the market’s reaction to the end of QE and how the economy performs afterward.   

I am confident that FOMC members want to end QE ASAP.  If true, then there is strong merit in the plan above.  However, is it also possible that the small change suggested above would act as a low-beta source of information as to how markets would react toward a more dramatic change in policy, such as a hike in rates.

“Though this be madness, yet there is method in it” – Shakespeare (Hamlet)


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