QE Through: Passing the baton to the private sector

Passing the baton
With the second edition of quantitative easing coming to a close at the end of June, there’s a lot of score-keeping about whether or not “QE2” was a success – and what will happen next.

Mike Dueker, Russell’s Chief Economist, recently shared his assessment of QE2, the Fed’s game plan, and how the difficult situation in peripheral euro zone might affect Fed policy. His perspective might be helpful as you contextualize for your clients what’s happening in the capital markets today – and what might happen in the next 12 months.

 QE2 = A success

When the Fed launched QE2 in November 2010, its primary objective was to get people to stop worrying about a double-dip recession and the risk of deflation. From that perspective, QE2 has been a success. Mike Dueker suggests looking at the 10-year Treasury bond yield as one indicator of QE2’s success. Its increase from 2.8% at the beginning of QE2, to 3.1%, at the time of writing, signals expectations for growth – not a further decline in prices.1

That being said, many investors are still consumed with worry – new worry. Worry about inflation, high unemployment, signs of continuing growth potentially disappearing as stimulus is withdrawn from the system, stocks declining as easy access to credit comes to an end. Doomsday scenarios also describe the debt-laden peripheral euro zone countries threatening to topple the global financial system.

What’s next?

First off, Mike does not expect the Fed to launch a QE3 nor for economic recovery to be stunted. Instead, he believes that in early 2012 the Fed will begin shrinking its balance sheet in an orderly fashion – by selling some of the securities it has been stockpiling during the QE programs. Mike believes this approach will result in a smooth transition for two reasons in particular:

  1. it gives the Fed flexibility to scale back its security sales if the economy turns out weaker than expected,
  2. it is a way for the Fed to offer the types of short-term securities that he expects the market will demand.

Further, he expects that when the Fed balance sheet reaches $2 trillion – in approximately June 2012 – the Fed is likely to increase interest rates for the first time. Of course, slower economic growth, a worsening employment picture, or unforeseen financial risks in the euro zone could delay rate hikes.

The Fed balance sheet and the price of real assets

In the coming months Mike says he’ll be watching the prices of real assets – especially gold – with interest. Since the launch of QE1 in 2008, the price of gold has increased dramatically, as demand for these assets typically viewed as inflation hedges increased.2 Mike warns that as the Fed’s balance sheet begins to shrink, the price of gold and other real assets may decline in tandem.

Sophie Gilbert is a director of capital markets insights for Russell Investments. View Sophie’s bio »

1 Source: Bloomberg

2 Source: Bloomberg

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