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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Bernanke Says Accommodative Policy Needed for ‘Uneven’ Economic Recovery

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Ben Bernanke, chairman of the Federal Reserve, gives remarks during the International Monetary Conference in Atlanta on June 7, 2011. Photographer: Chris Rank/Bloomberg

 

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June 7 (Bloomberg) -- Axel Merk, president and chief investment officer at Merk Investments LLC, talks about the reaction of financial markets to Federal Reserve Chairman Ben S. Bernanke's speech today and the outlook for Fed policy. Merk, speaking with Carol Massar and Adam Johnson on Bloomberg Television's "Street Smart," also discusses the outlook for the U.S. dollar and euro, and the European debt crisis. (Source: Bloomberg)

 

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June 7 (Bloomberg) -- Thomas Atteberry, investment manager at First Pacific Advisors LLC, talks about Federal Reserve Chairman Ben S. Bernanke's speech in Atlanta today and his investment strategy for bonds. Bernanke says the central bank should maintain record monetary stimulus to boost an "uneven" and "frustratingly slow" economic recovery. Atteberry speaks with Carol Massar and Adam Johnson on Bloomberg Television's "Street Smart." (Source: Bloomberg)

 

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June 7 (Bloomberg) -- John Brynjolfsson, chief investment officer at Armored Wolf LLC, talks about the outlook for U.S. Treasuries and Federal Reserve policy. He speaks with Carol Massar and Adam Johnson on Bloomberg Television's "Street Smart." (Source: Bloomberg)

Federal Reserve Chairman Ben S. Bernanke said record monetary stimulus is still needed to boost a “frustratingly slow” recovery and repeated that a rise in inflation is likely to prove temporary.

“The economy is still producing at levels well below its potential; consequently, accommodative monetary policies are still needed,” Bernanke said today in a speech to a conference in Atlanta. At the same time, the Fed “will take whatever actions are necessary to keep inflation well controlled,” he said.

Recent data showing weakness in the economy, including a rise in theunemployment rate to 9.1 percent in May, have increased the odds the Fed will hold the benchmark interest rate near zero into next year. Bernanke said growth is likely to pick up in the second half of the year as fuel prices recede and disruptions of parts supplies dissipate as factories in Japan recover from an earthquake and tsunami.

“Overall, the economic recovery appears to be continuing at a moderate pace, albeit at a rate that is both uneven across sectors and frustratingly slow from the perspective of millions of unemployed and underemployed workers.”

Treasury two-year note yields dropped two basis points, or 0.02 percentage point, to 0.4 percent at 4 p.m. in New York, the lowest level this year. The dollar fell against most of its major counterparts, with the yen reaching the strongest level against the greenback in a month. The Standard & Poor’s 500 Index fell 0.1 percent to 1,284.94 after rallying as much as 0.8 percent.

‘On Course’

“He’s saying monetary policy is on course and right on, and there’s no need to change at this point,” said Sung Won Sohn, an economics professor at California State University- Channel Islands and former chief economist at Wells Fargo & Co. “The implication is not only will there be no change, but a third round of quantitative easing is not likely to come.”

Bernanke said in April that the Fed would keep its balance sheet at a record level after ending a program to buy $600 billion in Treasuries, a policy known as quantitative easing, on schedule this month.

While a recent increase in inflation is a “concern,” Bernanke said today he doesn’t see “much evidence that inflation is becoming broad-based or ingrained in our economy.”

Still, “the longer-run health of the economy requires that the Federal Reserve be vigilant in preserving its hard-won credibility for maintainingprice stability,” he said.

Inflation Measure

The personal consumption expenditures price index, minus food and energy, rose 1 percent for the 12 months ending April. That’s below the longer-run inflation goal of 1.7 percent to 2 percent for the PCE index forecast by policy makers in April.

The breakeven rate for five-year Treasury Inflation Protected Securities, the yield difference between the inflation-linked debt and comparable maturity Treasuries, has fallen to 2.05 percentage points from 2.47 percentage points on April 29.

Breakeven rates are a measure of the outlook for consumer prices over the life of the securities. The measure has climbed from 1.24 points on Aug. 27, the day Bernanke signaled the Fed might embark on a second round of large-scale asset purchases during a speech in Jackson Hole, Wyoming,.

If commodity prices stabilize, “the upward impetus to overall price inflation will wane and the recent increase in inflation will prove transitory,” Bernanke, 57, said in today’s speech. Inflation is being restrained by “the stability of longer-term inflation expectations” and “weak demand for labor,” he said.

‘Loss of Momentum’

Bernanke said recent data on the labor market show a “loss of momentum.” He cited last week’s payrolls report, which showed that companies added 83,000 workers, down from 268,000 the month before.

Households are facing “significant headwinds,” he said, such as higher prices for food and energy, declining home values and still-high unemployment.

Oil prices have climbed 160 percent since February 2009, while non-fuel commodity prices gained about 80 percent, Bernanke said. The increase in commodity prices reflects “strong gains in global demand that have not been met with commensurate increases in supply,” Bernanke said.

The chairman rejected criticism that the Fed’s actions have pushed down the foreign exchange value of the dollar, and thereby boosted the price of commodities, saying “many factors other than monetary policy affect the value of the dollar.”

Commodities as tracked by the 24-member Standard & Poor’s GSCI Spot Index have rallied about 9 percent this year, led by gasoil and Brent crude.

Helping Dollar

Bernanke said the central bank’s efforts to keep inflation low and stable are helping the dollar.

“There is a very strong case that what the Fed needs to do to provide good fundamentals for the dollar in the medium term is to first keep inflation low and stable, and secondly to help the economy recover and be strong,” he said in response to questions after the speech.

Waning fiscal stimulus will also exert drag on growth, Bernanke said. He warned against sharp cutbacks at a time when the recovery is still fragile, while urging lawmakers to develop a long-term plan for deficit reduction.

Long-Term Plan

The chairman also said the Fed needs to do “more thinking” about how new rules requiring banks to hold more liquidity will affect the broader financial system, and that the central bank wants to create new regulations that won’t “unnecessarily constrict credit.”

Policy makers have few options left to respond to accumulating signs of a slowdown after their second round of asset purchases sparked the harshest political backlash against the central bank in three decades.

“We’ve gotten inconsistency, hesitancy and unevenness” in U.S. economic growth, Atlanta Fed President Dennis Lockhart said today in a speech in Charlotte, North Carolina. “I’m troubled by what you might describe as a lack of conviction in this economy.”

Two regional Fed bank presidents critical of the so-called quantitative easing program -- Richard Fisher of Dallas and Charles Plosser of Philadelphia -- reiterated their opposition to additional stimulus in comments yesterday.

The central bank has “done enough if not too much” to spur growth, Fisher said in New York, while Plosser said in Helsinki that an exit from stimulus should start “long before” a recovery in the U.S. job market is assured.

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