On Investors Who Expect QE3 in 2012

By Edward Harrison On Apr 16, 2012

Quantitative easing hasn’t worked to lower interest rates in the past but has caused a huge uproar from those opposed to the policy in the US. QE is therefore both ineffective and politically-charged. But a lot of people still expect it. Now three weeks ago, I ran a series of articles on this. See the following:

The overall gist here was that the Fed was not going to go QE3 but that it could continue rate easing or attempt to manipulate mortgages by buying up mortgage backed securities. My sense is that if the economy weakens enough, Treasury rates will come down on their own and the fed won’t need to do any QE to support lower rates (even though we know QE is not effective in this regard in the first place). That said, it is not clear that mortgage rates would follow Treasuries down as a slow growth economy would mean risk off and that could see widening spreads leading to higher mortgage rates. So, to me that is where the Fed could do so-called QE.

My money is still on rate easing/permanent zero whereby the Fed signals that it is committed to zero rates for longer. Janet Yellen, the Fed Vice Chair has suggested the fed could do permanent zero out to the end of 2015 if things start to get messy. So that tells me this is where policy is headed and not down the QE path. However, a number of leading bond investors are talking up QE including Bill Gross and Jeffrey Gundlach.

Here’s Bloomberg:

Bill Gross, Jeffrey Gundlach and Dan Fuss, whose firms collectively oversee about $1.5 trillion, expect the Federal Reserve to conduct a third round of bond purchases as signs of strength in the U.S. economy fade and Europe’s sovereign-debt crisis returns.

The managers at Pacific Investment Management Co. and DoubleLine Capital LP favor mortgage debt as Loomis Sayles & Co. purchases corporate bonds. Speculation that the Fed (FARBAST) will buy home-loan debt with quantitative easing has led 2012 returns on government-backed mortgage bonds to exceed Treasuries by 0.96 percentage point, Barclays Plc index data show.

Fed Chairman Ben S. Bernanke, Vice Chairman Janet Yellenand New York Fed President William C. Dudley signaled further easing may be needed if growth lags behind projections, with headwinds ranging from the end of tax breaks to $1 trillion of mandatory federal budget cuts to $100-a-barrel oil eating intoconsumer spending. The Standard & Poor’s 500 has fallen as much as 4.8 percent from an almost four-year high on April 2.

“Should the stock market keep going down, it will be a portent of weaker economic data,” said Gundlach, whose $22.8 billionDoubleLine Total Return Bond Fund (DBLTX) outperformed 99 percent of peers last year. “It will happen and when it does you will start to hear about more support programs.”

Gross, Fuss

While gross domestic product grew at a 3 percent pace in the last three months of 2011, it will slow to 2.3 percent this year, according to the median estimate of 90 economists surveyed by Bloomberg.

Gross, the manager of the world’s biggest bond fund, boosted holdings of mortgages last month to the most in almost three years. Fuss, a member of the Fixed Income Analysts Society Hall of Fame, said this week that the Fed may stick with quantitative easing until after the presidential election or theunemployment rate falls to about 6 percent from its current 8.2 percent.

So, at least Gross is talking mortgages. I just don’t see QE with Treasuries. My expectation is weakening US growth in the second half of the year accompanied by weaker earnings. This could precipitate monetary easing and I would anticipate: rate easing/permanent zero, mortgage bond program, or normal QE in that order of likelihood. But remember, this is an election year. The economy is going to have to be pretty weak for us to see any kind of additional monetary stimulus.