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QE Is Dead; What’s Next for Fed?

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While some await the drama of Game 7 of the World Series on Wednesday, market watchers have had their eyes and ears fixed on Chairwoman Janet Yellen and the Federal Reserve’s latest pronouncement.

The Federal Open Market Committee confirmed that it will not extend its quantitative easing policies and said it would keep interest rates low for a “considerable time.” The group also noted improved conditions in the labor market, which suggest the “underutilization of labor resources is gradually diminishing.”

“It’s clear that the Fed is not concerned about inflation, since it is below 2%,” said Brian Brennan, a fixed-income portfolio manager with T. Rowe Price, in an interview with ThinkAdvisor. “It’s a bit more hawkish than I expected, and there appears to be no concern about disinflation either, domestically or globally.”  

The fairly undramatic end to QE is “what the Fed wants,” Brennan says. Of course, he adds, when it comes to inflation and employment, the Fed shared that as information comes in it “could move up any change in the fed funds rate, as needed, or move conversely, if progress slows.” 

Ahead of the announcement, fixed-income and market analysts expected few surprises from the Fed – or from the markets.

“This is arguably the most widely anticipated policy conclusion in the Fed’s history, suggesting that the end of bond purchases may not create much market reaction,” said LPL Financial (LPLA) investment strategist Anthony Valeri, in an outlook report on Wednesday. Bonds closed higher on Monday, “showing that the lack of a major buyer is not a concern,” he explains.

“As long as the Fed is true to staying in the current pattern and ending taper, there should not be a strong reaction either way,” said Raymond James market strategist Ellis Phifer, in an interview. “Any change in language around growth could impact the markets.”

However, some experts expect longer-term fallout from QE’s end as the Fed juggles multiple challenges.

“The Fed must plan a ‘great escape’ from three things, but recent market volatility shows the challenges the Fed faces in doing do. The three escapes include: a liquidity trap — weak bank lending, quantitative easing, and the zero interest rate,” PIMCO said in a statement shared with ThinkAdvisor early Wednesday. “This escape hasn’t been and won’t be easy.”

PIMCO, however, sees low policy rates globally as fairly certain. Such low rates, it notes, “will continuously support equities and credit throughout the world.”

Bond investors, Valeri says, are focused “more on global economic growth and expectations for interest rate hikes.”

Big Breakup

Still, the Fed’s “breakup” from quantitative easing is not likely to be “a clean one as it maintains a steady influence in the mortgage-backed securities (MBS) market,” Valeri explained in a report issued before the release of the FOMC statement. 

Just because the markets reacted dramatically in the past, such as in 2004, to higher interest rates does not mean that will always be the case, says Phifer.

“The yield curve flattened a lot, and the equity markets did OK. The Fed is more concerned about being verbal and careful, which it will be. It wants to remove extraordinary monetary policy — extended QE and zero lower bound,” he explains.

If (or when) the Fed mores to a 2% real rate to offset inflation, “It’s a good rate to get to, and the markets should not see dramatic moves,” Phifer added.

Lawmakers were quick to weigh in with their comments on the Fed’s decision.

“The end of QE is good news,” said House Financial Services Chairman Jeb Hensarling, R-Texas, in a statement. “While many believe monetary accommodation was necessary in 2008 and 2009, the Federal Reserve allowed its extraordinary measures of the financial crisis to become its ordinary policy.” In both time and money, Hensarling said, “QE has overstayed its welcome by years and by trillions.”

Rep. Randy Neugebauer, R-Texas, chairman of the House Financial Services Subcommittee on Housing and Insurance, expressed in his statement his fears that “the long-term legacy of the [QE] policy will reflect the harm it has done to our nation’s seniors, savers, and all Americans faced with greater uncertainty and the possibility of a QE-induced bubble.”

The Fed’s “easy money policy,” Neugebauer said, “has only made it easier for the federal government to add trillions to our national debt, while creating precarious conditions in the corporate debt and high-yield markets.”

Neugebauer said his “hope” is that the Fed’s Wednesday announcement “marks a permanent end to QE and a shift to a more rules-based monetary policy that will benefit all Americans and lead to greater long-term economic prosperity.”

‘Great Escape’

The challenges facing the Fed are formidable, according to PIMCO: It must “design an escape that avoids upsetting too quickly the three main objectives it has had ever since it began its extraordinary monetary accommodation in 2008, which is to make investors believe interest rates will be low for a long time to come, keep bond yields stable at low levels, and prod investors to take risk and buy equities, corporate bonds and other financial assets.”

That means the Fed can’t upset stock prices, bond yields, credit spreads, bank lending standards or the U.S. dollar.

The fixed-income shop adds that there should be a “stock effect” from the Fed holding $4.2 trillion of securities, since these securities cannot be traded in the marketplace. This effectively reduces the supply of investable assets, “placing downward pressure on market interest rates, even without any new buying from the Fed.”

The bond group is upbeat on the stability provided by low policy rates to equity and credit markets. However, when the Fed actually raises rates to 2%, this will be similar to a 3%-4% jump, “because the Fed will be combining its rate actions with balance sheet actions, a massive amount of total tightening,” PIMCO explains.

Long Goodbye

It hasn’t been an easy end to the Fed’s relationship with QE.

The sharp drop in bond yields during the summer of 2011 was due in large part to the Fed’s announcement that would remain on hold for nearly two years, reducing a key source of interest rate risk at the time.

Investors should keep their eyes on global trends, notes LPL’s Valeri.

The tapering’s end is “just a distraction from one of the two primary drivers of bond yields — global economic growth,” he says. “In an increasingly connected global financial market, U.S. bond yields are more sensitive to the global economic environment.”

Expectations, of course, play a key role.

“In recent weeks,” he explained, “bond investors have dramatically scaled back their expectations, providing additional support for bonds.”

The Fed’s first rate hike, Valeri says, is now priced in for late 2015.

“Expected changes in short-term rates, along with economic growth expectations, are likely to maintain a greater influence over bond yields than the quantity of bonds the Fed is purchasing,” the expert said.

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