QE3: CoveringThe Market With Liquidity. How Will It All End?

economistYesterday U.S. equities fell the most in five months in a broad-based sell-off that took a heavy toll on commodities as investors sold off riskier assets and reacted cautiously in response to weaker than expected first quarter Chinese GDP.

Today market bulls are quick to point out that equity futures are pointing solidly higher and quantitative easing (QE3) remains firmly intact for the foreseeable future.

Market bulls believe that QE3 is a floor for the market and remains a strong catalyst for equity markets to keep pushing higher.

QE3 was announced on September 13, 2012 after the Federal Reserve decided to launch a new $40 billion a month, open-ended, bond purchasing program of mortgage-backed securities while pledging to continue their policy of having low rates policy until at least mid-2015.

Three months later on December  12, 2012 the Fed announced that they would expand the amount of open-ended purchases from $40 billion to $85 billion per month in an effort to push down long-term borrowing costs and spur  hiring.

The housing market has directly benefited from the Fed’s aggressive monetary easing stimulus program because more homeowners are able to purchase homes at historically low interest rates which in turn acts as an incentive for more home purchases and construction.

Under Chairman Ben Bernanke the Fed has kept short-term interest rates close to zero for over four years, promising to keep them low until there is a substantial improvement in the labor market.

The Fed announced it would be willing to tolerate expected inflation up to 2.5 percent as long as it helps to move the unemployment level below 6.5 percent, the breaking point whereby the central bank may begin to consider raising interest rates.

However, there are some risks that come along with enacting aggressive monetary easing policies.

By expanding the Fed’s balance sheet to $85 billion every month through the purchase of securities, there are some investors who remain concerned that the Fed is creating an asset bubble in equity markets and could be setting themselves up for future problems when they have to unwind their balance sheet which is weighted heavily with mortgage-backed securities.

In this essay that was carried by the International Monetary Fund (IMF), some of the future challenges with the Fed unwinding their balance sheet overweight securities were cited.

“The central bank may face challenges exiting markets in which they have intervened heavily, including the interbank market; policy missteps during an exit could affect participants’ expectations and market functioning, possibly leading to sharp price changes.”

Mark Zandi, chief economist at Moody’s Analytics, shared his views on Bloomberg’s Countdown about how he thinks the Fed could end up unwinding their large balance sheet.

“My view is that they can pull this off. They need to communicate very clearly exactly how they are going to do this and they’re going to have to wind down their balance sheet in very orderly and graceful way” Zandi explained.

When asked about if the Fed could begin to wind down their position this year, Zandi indicated that the Fed could start scaling back their purchases before the end of the year.

“If you told me that by the end of the year that they start to scale that back ($85 billion in monthly purchases) that sounds about right to me. But I don’t think they end QE until sometime in 2014” Zandi said.

 

 

 

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