12 Jun 2011

Fed Officials Say No QE3; Market Says Think Twice- 18 days to go


-Feds squash prospect of QE3, but Treasury market says economy needs support
-Treasurys rally echoes pre-QE2 environment
-QE3 or not, analysts question the effectiveness of more bond-buying

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Federal Reserve officials have all but killed the idea of a third round of large-scale asset purchases, but a defiant Treasury rally indicates many believe the U.S. economy may need more help.
"Investors are beginning to get the feeling that QE3, or some new sort of Fed stimulus, may not be a pipe dream after all," said Kevin Giddis, president of fixed income capital markets at Morgan Keegan. "I find it fascinating that we are quickly moving into this camp some two weeks before QE2 even ends."
Aside from a few profit-taking sessions, the Treasurys have rallied since early April, with yields repeatedly booking new lows for the year. And with benchmark 10-year yields snuggly below the psychologically key 3.0% level, no amount of debt-ceiling anxiety or inflation warnings seems to be able to scare investors out of the arms of U.S. government debt.
Instead, fears are centered on stalling U.S. and global growth. Weak housing, labor, manufacturing and retail reports have plagued the U.S. for more than two months, while policy tightening across major foreign markets is starting to take effect.
The rally in safe-haven Treasurys is eerily similar to the one in the months leading up to the announcement of QE2.
"It seems like deja vu all over again," said Jeffrey Cleveland, senior economist at money manager Payden & Rygel, recalling a similar flight to Treasurys last June, when the Fed originally rejected the need for a second round of bond-buying.
"Feds said no...but the market was in front of that and had rallied to [take benchmark yields] to 2.30%."
While Cleveland believes a third leg is unlikely and that financial markets have been a bit "carried away" with the recent doom and gloom, he said a benchmark yield of 2.50% would reflect a pricing in of further Fed stimulus. The 10-year note was trading up 8/32 in price to yield 2.971% late Friday.
Stephen Van Order, fixed income strategist at Calvert Asset Management with $ 14 billion under management, said he sees a higher, "non-trivial" chance of more Fed assistance. If there was a 5% chance of QE3 earlier this year, there's about a 15% chance now, he said. Especially with authorities on the fiscal side cracking down on spending, the "Fed is the only game left in town."
Still, the hurdle is high--most notably the lack of disinflation fears that were present last year. Plus, the market will likely shrug off a new package of say, $300 billion in the form of additional bond purchases, since there is a " diminished utility" effect given how bloated the Fed's balance sheet has already become.
To that effect, the two-month scramble into Treasurys could also reflect market participants bracing for a world without Fed stimulus. Most analysts say the end of the Fed's nearly day-to-day bond purchases will hit equity markets hardest and send more money into U.S. government debt.
Senior portfolio manager Sean Simko at SEI Fixed Income Portfolio Management said while there is increased chatter about QE3, there isn't an increased likelihood of it actually happening.
"It remains a low probability, a tail event," Simko said. "QE1 secured the economy," QE2 followed it up to make sure it worked, "so with diminished utility set in motion, QE3 would have to be even larger" to be effective.



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