Will QE2 end in fire or ice?

May 26, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — With just a month to go until the Federal Reserve brings QE2 to a close, most analysts are focused on the risks to markets if interest rates shoot higher when the government is no longer buying its own debt.

But an alternative is worth considering: what if this buying binge by the Fed is followed not by that fire but by the ice of sinking yields and another lurch towards deflation.

Albert Edwards, a trenchantly bearish strategist at Societe Generale, maintains that Treasury yields are heading lower and that this will be accompanied by the mother of all busts on the stock market, taking the S&P 500, currently at about 1,325 points, to 400.

Yes, that’s right, 400.

“Despite fully acknowledging the ruination of the government balance sheets as years of excess private sector debt are transferred to the public sector, we still expect to suffer another deflationary bust that will take government bond yields to new lows before government profligacy and the Feds’  printing presses take us back to both double-digit inflation and bond yields,” Edwards said in a note to clients. “For now, we remain heavily overweight government bonds.”

The more mainstream concern is that the ending of the second round of quantitative easing will remove a key support for Treasuries and that few will be willing to buy when the Fed is not, especially given the uncertain outlook for the budget and inflationary pressure from commodities and energy.

At the same time QE2 is ending, Chinese and emerging market tightening may mean less natural appetite for Treasuries. If China decides to allow its yuan to strengthen to fight inflation, this will be exacerbated. China must buy Treasuries to recycle export dollars and keep its currency cheap. If China decides to ease up on that policy there will be fewer Treasuries purchased.

Edwards thinks, though, that this will be swamped by weak economic fundamentals and a sell-off in risk assets. Both of these forces would send Treasuries higher, even despite the absence, at least temporarily, of the Fed as a big buyer of government debt.

So, in this scenario, the money that was displaced by the Fed during QE2, money that poured into risk assets, particularly bonds, comes flooding back to Treasuries, driven by fear of an economic downturn and seeking safety from carnage in the corporate markets.

Mark my words, if Treasuries do rally after the end of QE2, even if they are rallying due to a recession, we can expect the Fed and the Treasury to immediately claim credit for having wisely earned the U.S. profits by buying up its own debt.


Treasuries could also get a boost, strangely enough, if the U.S. fails to raise the debt ceiling by the Aug. 2 deadline, sending itself into a semi-default. In this scenario, espoused by Rob Dugger of Hanover Investment Group, money would pour out of stocks and bonds of companies which would be hurt by a government shutdown, either via higher taxes or lower government expenditures.

While this money flows into Treasuries some may take a polite default by the U.S. as positive for longer term Treasuries, on the view it makes the politically difficult task of cutting expenditures and raising taxes that much more likely.

It would certainly be poisonous for stocks and corporate bonds, as indeed should be recent signs of weakening in the U.S. and global economies.

U.S. durable goods orders was the latest in a string of disappointing data points, as they showed the largest fall in six months, considerably worse than analysts’ forecasts, on weak orders for aircraft and autos. Adding to this are recent signs of faltering growth in Japan, China and Europe, all of which has doubtlessly been partly caused by natural and man-made disasters in Japan.

The trials and follies of the euro are another prime reason to consider a Treasury rally. First off, the austerity being imposed on Greece, Portugal, Spain and Ireland are a profoundly deflationary force in themselves, a dampening of demand and cheapening of production that in aggregate is important.

What’s more, the risk of a Greek default, much less it coming to reality, will surely send investors scuttling for safety. While Swiss and Canadian debt and gold may be more deserving havens, they are not nearly large enough and considerable money will flow where it always does in times of uncertainty and stress: to Treasuries.

None of this is to imply that Treasuries are a fundamentally sound investment. The risks of inflation and a foreign sell-off are real, and you can bet that a new economic downturn will be met by new policy errors, or perhaps just the same policy errors all over again.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article.


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How about neither fire nor ice but a tepid puddle that stagnates with a few spectacular water lilies and the rest of us slipping into the ooze?

Posted by paintcan | Report as abusive

That puddle might actually be created by the simultaneous occurrence of both fire and ice. They exert forces in generally opposite directions, but we might find that they are not mutually exclusive.

Posted by breezinthru | Report as abusive

Yes, Treasures could rally short-term under the assumption that after a default US bonds are perceived having the same risk level (safe haven). Is this likely under default in combination with a less liquid market ? Difficult to say.
Great column by the way, thanks.

Posted by FBreughel1 | Report as abusive

Great article, China is the wild card, however it has bigger fish to fry.
It just cut subsidies to its wind turbine industry, reduced loans it lends to people seeking real estate via increasing the amount one must put down…and quite frankly their real estate bubble may burst just as in the US.

But with that being said, China is already dumping US T notes quietly. As you correctly said it must do so slowly so as not to put pressure on the yuan, however it wants no part of the American debt.

If the US defaults, even technically, you will see China and India respond by dumping more Treasuries. I just don’t see people wanting to have anything to do with Treasuries after Moodys slashes our triple A credit rating, and the market goes down so fast trading will be forced to stop.

Since when does insanity get to mainstream? Because that is exactly what a technical default would do. Play with China, I dare you…they already told the US that to play with teh debt ceiling is to play with fire. Trust me you don’t want to get them “concerned” because despite the brinksmanship, and phone calls by our so called heads of state and some republicans, China will do what China WANTS to do and all bets are off if the US defaults.

Posted by Independent007 | Report as abusive