QE3 - A Second Look

Location Date: 
August 31, 2011

I must admit I was really impressed by Mr. Bernanke’s Jackson Hole speech released last Friday morning.  I thought it struck the right balance and, more importantly, did not suggest any immediate quantitative easing.  While markets initially sold off, they later rallied to close higher. My thinking was that if the FED held off, forced the government to take concrete steps on the deficit but kept its’ options open, then markets would come around.  It now appears that my view was naive for a number of reasons.

Firstly, the release of the FMOC minutes yesterday of the August meeting were indicative of further stimulus ahead in particular via a focus on dampening longer-term interest rates (“Operation Twist” as noted in the last blog post).  This was evidenced in the fall in 10-year bond yields and the rise in equity markets over the past few sessions.  JP Morgan’s excellent strategist Michael Feroli added his voice to the chorus stating “we believe the minutes lend themselves to our view that there is a somewhat better-than-even chance the FED takes action at the next meeting to increase the average maturity of assets on their balance sheet”.

Secondly, we learned that one of the three dissenters of the FED’s promise to keep rates extremely low through mid-2013 is turning more dovish.  Minneapolis governor Kocherlakota is now in the “falling inflation” camp and is more open to QE if the economy falters.  As well, all three dissenters (including Plosser and Fisher) lose their “voter” status at the end of 2011, potentially making Bernanke’s job less stressful as the newcomers appear dovish.

Finally, we heard from uber-dove Chicago Governor Evans yesterday in a CNBC interview.  His comments put $25 on the price of gold in a heartbeat.  His position is clearly in the camp of dramatic further accommodation – so much so that he makes Bernanke look downright hawkish.

All of this suggests QE3 is now back on the table.  The September 21 meeting will be very closely watched but markets seem to be putting the odds squarely on it happening.  We know the consequences of this kind of policy – commodities, especially oil and gold, should do extremely well.  Stocks should bounce and government bond yields should be stable to down.  Look for a bounce in credit markets – especially in leveraged loans which have performed horribly in August.  We also know that the effects are transitory - enjoy the high while it lasts.

Jim McGovern