Fed Out of Bullets: QE2 will keep the status quo

Author: The upcoming announcement by the FOMC regarding QE2 will be a non-event. It will chart the course for allocation of huge sums of money toward a policy that will have little effect toward it's goal. It is estimated that the Federal Reserve will print US currency to buy assets to inject money into the financial system.

Regarding the planned purchase of treasury instruments: the only objective, and a noble one, should be to keep rates where they are, and not allow them to rise. At some point if they keep rigging the auctions too long, there will be a run. This is just prolonging the elevated pricing for the treasuries, but cant move the price any higher.

But I do see Fed continuing to buy hefty amounts of mortgage debt. The whole Fed strategy relies upon the mortgage market remaining steady and solvent. During the last few years a drop in long term mortgage rates has enabled a new refinancing binge that helps alleviate the overhang of underwater mortgages. Now that rates are near rock bottom, this trick has more risk of boomerang if the securities are deemed to be low quality at high prices. The implications are too horrendous if mortgage rates rise even a percentage point.

Prediction: Total of $500B USD purchase over six months, including $350B mortgage and $150B treasuries

Not enough to move the market, but enough to scary anyone away from shorting the market.

What does this mean?

1) USD should bounce
2) Emerging markets should correct mildly
3) Treasuries should hold steady for the foreseeable future (I think they will be successful in that)

For a retrospective look at what Helicopter Ben has hinted as options for QE2, refer to the following article from LA Times, July 22: "Federal Reserve gives us insight into Plan B"

"Fed Would Act if Needed, Chairman Says
Ben S. Bernanke, emphasized on Thursday that the central bank was prepared to take action if needed. (July 22)

In his testimony on Thursday, Ben Bernake warned of “unusual uncertainty” in the markets but said the Fed had no immediate plans to deploy additional tools of monetary stimulus.
“We are ready, and we will act, if the economy does not continue to improve, if we don’t see the kinds of improvements in the labor market that we hope for,” Mr. Bernanke told Representative Melvin L. Watt, Democrat of North Carolina, in the second of two days of hearings on monetary policy…."

"First, he said, the Fed could make clear to the markets that it planned to keep the federal funds rate, currently set at zero to 0.25 percent, for even longer than the “extended period” it has been projecting for months."

Author: uhhhh….this is called “do nothing and hope what we have already done eventually works”. Fed Funds rates are already at zero. I have read that the “real interest rate” with deflation counted in is currently 5%. But the nominal interest rate is already at the lower bound.

"Second, the Fed could lower the interest rate it pays on excess reserves — deposits banks hold at the Fed in excess of what they are required to — from its current level of 0.25 percent."

Author: uhhhh….are you kidding me? Is it really going to make that much of a difference to lower the excess reserves rate from .25% to 0%?

"Third, the Fed could expand its balance sheet, which already stands at $2.3 trillion, primarily by purchasing additional assets, whether in the form of additional government debts and mortgage bonds, or in the form of new assets, like municipal bonds."

Author: Ahhh… here we go…. More of the same thing done before…. Maybe something beyond mortgage bonds which can’t drop much lower than the current 5% yield. The Fed can start buying Greek bonds, Dubai debt, Spanish Banks, US auto loans, US credit card loans and everything else put on the market. I would hate to be a shareholder of one of the US Federal Reserve Banks right now. Forced buying does not make for very good return on investment prospects.