A slew of weak economic data has raised concerns that the U.S. is in a recession. Recent reports suggest that the Fed is ready to act.Bank of America strategist Priya Misra and her team have revised their Fed call and expect that Fed will act when it is “comfortable that the growth slowdown is likely to persist”.
Here’s what BofA expects from the Fed:
- An extension of its forward guidance in a manner that would push rate hikes through late-2015 on August 1, against BofA’s earlier call for extension through mid-2015.
- $600 billion in quantitative easing (QE3) in treasuries and mortgage-backed securities (MBS) on September 13, up from the previous forecast of $500 billion.
The Make Up of QE3
The total asset purchases will be split evenly between treasuries and MBS with a similar duration buying to QE2.
“The size and composition of the Fed’s MBS purchases are critical. Note that Fed reinvestment of its MBS and agency debt portfolio has been running at $25- 30bn per month, absorbing almost 25% of monthly gross issuance. Assuming that the Fed is willing to take this share up to 50% of gross issuance would suggest an additional $25-30bn in purchases per month.”
The Fed is also likely to finish Operation Twist, which aims to lower long-term interest rates by selling short-term bonds and buying long-term bonds, before starting treasury purchases.
QE3 is expected to be less effective in boosting the U.S. economy than the previous balance sheet expansions and markets have already priced in 65 per cent of QE3 according to Misra.
Moreover there are a few key differences between the economy and expectations now than during the previous rounds of quantitative easing. First, fiscal policy is likely to be tightening this time around, global growth is weaker, the dollar is unlikely to weaken as much as it did during QE2 because of the deepening of Europe’s debt crisis, finally markets expect QE3 to be less effective in spurring and economic recovery. Mira writes:
“If the market has already priced in QE3 by the time it is announced, then its announcement should not result in much of reaction in yields per se. Ultimately, the fundamentals of growth and demand-supply for duration will drive rates.
However, if the announcement of QE3 is met with cheer in the stock market and commodities, we can expect a knee jerk reaction of higher rates and higher inflation expectations, though it appears that stocks are already pricing in high odds of QE3. We could see an increase of 15bp-20bp in 10y rates if risky assets applaud the Fed easing step.
We expect this “risk on” trade to be short lived. We believe that the stock market will eventually realise that the benefits of QE are easily overwhelmed by the fiscal cliff and Europe. Hence, we recommend fading any significant increase in Treasury rates on a QE3 announcement effect.”
Despite all this consensus is building that QE3 will be ineffective in bolstering the economy in part because an increasing number of corporates and households are beginning to realise Fed policy is not a cure-all. While the absence of QE3 would be negative for confidence and the economy according to Misra, the easing will in no way be a “game changer”.
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