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Catching a Falling Financial Knife

Will the Fed End QE Summer 2013?

Interest-Rates / Quantitative Easing Jan 30, 2013 - 04:30 PM GMT

By: Money_Morning

Interest-Rates

Jeff Uscher writes: Amid all of the hoopla over the Standard & Poor's 500 Index touching 1,500 on Friday, it seems few people noticed that the yield on 10-year U.S. Treasury bonds has risen to within a couple of basis points of 2%. That is nearly 30 basis points higher than it was one month ago and 10 basis points higher than one year ago.

It seems as if the bond market is beginning to price in higher inflation at the long end of the yield curve, and that is something that has got to be worrying the Fed.


Successive rounds of quantitative easing (QE) have added a lot of liquidity to the U.S. economy and this has been repeated globally with massive amounts of liquidity being pumped into the market by the Bank of Japan (BOJ), the European Central Bank (ECB) and the Bank of England (BOE).

The Bank of Japan has committed itself to further aggressive easing under pressure from the newly elected government headed by Prime Minister Shinzo Abe. Even if BOJ Governor Masaaki Shirakawa has any second thoughts about additional easing, he will keep them to himself.

Why Some Central Bankers Are Worried
Other central bankers have raised a warning flag.

BOE Governor Mervyn King told the U.K. parliamentary treasury select committee last week, "One of the things we ought to be a bit concerned about is interest rates have been so low for so long...that the search for yield appears to be beginning again...A combination of a weak recovery and yet at the same time people searching for yield in ways that suggest risk isn't fully priced is a disturbing position."

And Kansas City Federal Reserve Bank President Esther George said in a Jan. 22 speech, "In promoting its longer-run goals, the FOMC must weigh the benefits and the risks of maintaining an unusually accommodative monetary policy stance for a protracted period...Monetary policy, by contributing to financial imbalances and instability, can just as easily aggravate unemployment as heal it. Economic models tend to highlight the benefits of such a policy, but cannot fully account for the future risks."

George continued, "I have highlighted the risk of financial instability and the risk of higher inflation because, although some say they are unlikely, history shows that becoming too sanguine about either can lull us into thinking we can avoid them."

QE and Instability vs. Inflation
Julian Brigden, managing partner of MI2 Partners, raises an interesting point: "It is also important to understand that ending QE does not necessarily signal the beginning of monetary tightening."

Brigden said "the much more likely scenario is that by the summer, the economy is still only trundling along and unemployment is sitting in the 7.5% range. The idea of rate hikes at that point is a joke. Yet, QE could still end, simply because this tool of monetary policy hasn't delivered sufficient real economic growth, while building greater financial risks in the system."

The question is how much the bond markets depend upon asset purchases by central banks for maintaining current prices.

In the U.S., it seems as if higher yields (lower prices) for Treasury bonds at the long end of the curve are telling us that the end of QE might mean the end of ultra-low, long-term interest rates.

This has ramifications that go far beyond the Treasury bond market. For example, mortgage rates are usually based on 10-year Treasury bond yields.

If 10-year Treasury yields rise, mortgage rates, which are now near all-time lows, could reverse and start to rise too. What would that do to gathering momentum in the housing market?

Yet, it is dangerous to just keep pumping money into the economy through QE.

Last week, Federal Reserve Chairman Ben Bernanke dismissed the idea of imminent inflation but indicated that the continuation of QE would be evaluated on a risk/return basis.

"As we evaluate these polices, we're going to be looking at the benefits which, I believe, involve some help to economic growth to reduction in unemployment," Bernanke said. "But we're also going to be looking at cost and risk."

Maybe it is still too soon to call the end of QE. But investors should be aware of and sensitive to that possibility.

The Treasury bond market might be telling us that it won't take a rate hike to push yields higher at the long end of the curve. Just turning off the money spigot might be enough to push us over the edge.

Source :http://moneymorning.com/2013/01/30/the-doomsayers-are-wrong-about-oil-prices/

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Catching a Falling Financial Knife