Wednesday, March 16, 2011

Will QE2 be reversed in June? If they do, who'll buy the treasuries?

PIMCO seems to think so, and in that regard, they are now fully out of Treasuries. Yes, the world’s biggest bond funs is out of Treasuries in anticipation of the June end of QE2, with the expected increase in government cost of borrowing the end of the program entails. In fact, Bill Gross, PIMCO co-managing director, asks: With Fed responsible for 70% of Treasury purchases (foreigners being the rest), who would buy Treasuries after the Fed stops buying, and starts selling?

My $0.02, QE2 will not be reversed in June. Here are my reasons:

1. QE2 forced investors to take on more risk, to get into stocks, commodities, emerging markets, even synthetics. A reversal of QE2 will certainly lead to CC2 (Credit Crisis 2)

2. Because people/investors are still leveraged (In fact, QE2 encouraged them to further leverage, with its negative interest rates and corresponding rising asset prices). Those who could still borrow bought into assets, and rising rates would lead those over-extended and over-leveraged into, probably, an even worse situation than if there had been no QE2 at all.

3. A reversal of QE2 also means falling asset prices, as people exit out of risk positions. Hence, the Fed will likely have less credibility the next time it undertakes QE3, etc. QE’s effectiveness lies in people’s belief that it will raise asset prices, and hence, their wealth.

4. The Fed is already probably into NGDP targeting, which as we previously discussed, targets a 5% (or more) annual NGDP as a means of stimulating growth. So since RGDP still doesn’t have its own legs, 5% target means more easing is still on the horizon.

The genie is out of the bottle, you can’t just bring it back so easily. In the off chance I am wrong, and the Fed does reverse QE2, well, I see no downside at least for PIMCO. In fact, QE2 may have given them ‘found money’. They sold out of Treasuries when QE2 dropped yield. Why wouldn’t they buy when QE2 reversal jacks yields right back up? To answer PIMCo’s question: Who would buy Treasuries after the Fed stops buying, and starts selling – PIMCO seems like the best candidate.

And if the Fed ends up the losing side? Don’t worry, the Fed is already on it.
Update: Above statement clarified here.


Detroit Dan said...

I'm confused by "reverse QE2" terminology. Wouldn't the Fed just stop purchasing Treasuries? Reverse implies that the Fed would sell the Treasuries back, which is not the same as stopping further purchases...

Rogue Economist said...

By reverse, I take it to mean selling Treasuries back to the market. Not just stopping its purchases.

The Fed should stop buying ASAP because the more it buys, the more it encourages risktaking, the more dangerous it becomes to reverse.