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Out of the ICU

By Adam Baley                          

On June 22, the Federal Reserve formally announced it would end its $600 billion bond-buying program – known as QE2 – on schedule, as of the end of June. Not surprisingly, the yield on the 10-year Treasury note ended where it started the day, at 2.99%. No one was caught off guard as the Fed had telegraphed its move for months.

The announcement to end the second round of quantitative easing on schedule was a vote of confidence in the economy and a sign that, at this stage, the economy can and must begin to stand on its own, apart from massive central bank intervention. 

Despite its confidence, the Fed will continue to hold steady its $2.8 trillion balance sheet, ready to lend support if needed. In addition, analysts expect the Fed to hold target interest rates historically low at 0%-0.25% for the next three- to six months.

Eventually, the Fed will raise rates. Investors could then begin to expect yields on money markets and CDs to follow. 

By stopping its regular purchases, the Fed – the largest direct buyer of U.S. Treasuries – gives investors more influence over the 10-year Treasury yield. Conventional wisdom would expect long-term rates to rise, steepening (normalizing) the yield curve, as government intervention winds down. (Caveat: A further decline in Europe’s ability to pay its debt could prompt investors to flee to the safety of U.S. Treasuries, pushing yields back down.)

Although the Federal Reserve ended its scheduled $600 billion purchase of Treasury securities June 30, it still has other tools to try to stimulate the U.S. economy. In minutes from its June Open Market Committee meeting as well as congressional testimony from Chairman Ben Bernanke, the Fed has held open the possibility of “additional policy support,” if needed. However, Bernanke also told Congress that such measures are not imminent.

A steep yield curve is a sign of a healthy economy. In addition, it encourages banks to lend because they can profit on the spread between receiving short-term deposits and issuing long-term loans. Thus far, the lack of bank lending has hindered the recovery.

This second round of quantitative easing was mainly designed to hold longer-term rates low by raising bond prices. Arguably, it has contributed more to the rise in stock prices because, as the Fed intended, QE2 made investing in other assets more attractive. As a result, the end of QE2 will likely cause short-term volatility in both stocks and bonds as the market finds its equilibrium.

Despite the expected day-to-day price fluctuations, stocks still look historically cheap based on what investors are paying for expected earnings. Bonds, though we don’t own them for price appreciation, are historically expensive.  It’s hard to see how bond prices could rise from here. Expect your interest payment and nothing more from bonds. In fact, investors should be prepared for bond prices to slip as the economy gains traction.

A looming concern is fiscal tightening, as politicians weigh spending cuts and tax increases. The Fed wouldn’t want a repeat of the 1930s, when the government tightened too soon, ending a fledgling recovery. The Fed is acutely aware of market history and will likely continue easy monetary policy as politicians prepare to tighten fiscal policy.

Like a patient being moved out of intensive care, the body may struggle at first, unaccustomed to functioning without all the medical aid, but it should ultimately regain its strength. The economy is moving out from the aid of QE2, but it may take some time to fully recoup its vigor.

Adam Baley is a registered representative and associate at Landaas & Company.

initially posted July 14, 2011

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