ECB/Fed Support for the European Banking System - 750 billion USD, and counting ...

One point that I have been shouting from the proverbial roof tops in my research, to partners and colleagues is that 2012 may well be the year when all major central banks will be conducting both conventional and unconventional monetary easing at the same time. I think this is a very strong testament not only to the severity of the ongoing debt crisis in the developed world, but also to the propensity of central banks to choose inflation as the  desired route to recovery. We need not initially discuss whether they are deploying the proper set of policies or even whether such policies represent moral hazard or a ponzi scheme on government debt.

The main thing is to realise that this is an unprecedented global monetary experiment. 

My message to investors in 2012 would then be not to underestimate this inflation bias by part of global central banks. Inflating your way out of too much debt won't work in the long run without considerable defaults and/or economic stress (hyper inflation). Events since 2008 are ample evidence of this, but the simultaneous inclination to create inflation and debase your currency (to generate more inflation and exports) by all major central banks will continue to exert a profound effect on asset prices and the global economy. 

In so far as goes the idea that an investors' interest in asset prices is conditioned on return and volatility we can say that central bank policy will affect both. Financial assets will certainly benefit from excess liquidity, but the unravelling of too much debt through inevitable defaults and the central bank policies themselves will generate volatility. Whether the combination of such volatility and return means that you should stay out of the market entirely is a question for the individual investor. 

From a macroeconomic point of view, the downbeat assessment remains however that it is difficult if not impossible to paint a picture of where sufficient growth is going to come from and on the investment side of things, the higher level of volatility will tend to shake the foundation of investors even if money is to be made for short periods of time. 

Most attention has been centered on the ECB, whether the 3y LTRO represent QE and whether the continuing rejection to buy government bonds outright means that the ECB is a laggard among global central banks (see this excellent report by Hinde Capital for additional analysis relative to the points below). 

750 Billion USD,  and counting ... 

Europe remains the center of the global debt crisis, a role the continent has now decisively taken over from the US which stood at the forefront in the initial phases of the crisis in 2008. Apart from the almost endless summits and meetings among government officials the significant measures continue to be the ones coming from the ECB.

In my view, the European interbank market is virtually dead and dusted, and the ECB and the Fed are now effectively the only thing between Europe's banks and large scale failures. Since early September 750 billion USD worth of liquidity has been provided to the European banking system of which 100 billion sits on the Fed balance sheet through USD swap lines.

Who will bet against the final 3y LTRO auction to take this beyond one trillion USD?

Spanish and Italian curves are now nicely steep again after a brush with inversion which obviously was one of the main objectives even if it was always debatable whether banks would buy government bonds with the liquidity taken up at the ECB.

The question is; how do you unwind all this? 750 billion USD to roll short term liabilities with the ECB and the Fed seems to me to be one of the biggest gamble in monetary history. 

While the BOE and the Fed have been transparent in their QE efforts and the BOJ never really having left the zero bound the ECB has been more covert. However, it is my contention that with the expansion of the securities market programme (SMP) in 2011 to buy considerable amounts of government bonds (1) as well as the 3y LTRO the ECB is now fully engaged in quantitative easing.

I base this on two points. 

• The ECB has acted as a sovereign debt buyer of last resort in times of crisis. It is common knowledge in the market that the ECB has been Italian and Spanish bonds in times of particular stress on the notion that these two economies in particular could not be allowed to fatally succumb to the debt snowball dynamics.

• ECB support for the banking system in the form of collateralised liquidity and wholesale funding is not temporary but structural and permanent in nature. The interbank market in Europe is not working and has not been working since the crisis started in 2008.

The ECB will of course vehemently deny this but investors should understand that such denial is mainly out of political reasons.  When Draghi unveiled the ECB’s attempt to backstop the crisis in Europe by offering full allotment liquidity on a 3y basis, the market was disappointed because the central bank president also reiterated that the ECB would not step up its purchases of government bonds.

I think that the ECB will be forced into a much more direct and active role where unsterilized purchases in the primary market (monetisation) will be needed, but I fully appreciate the political issues. We are currently in a delicate situation where new governments in most of the involved countries are saddled with forced mandates to impose austerity. It is very difficult for all parties involved to push this agenda if the ECB had stepped up a full backstop. Moral hazard risks are consequently paramount here.

As such, investors must content with the ECB’s attempt to shore up the European banking system which is no little feat given the bank rollover schedule in 2012  as well as new Basel II regulation which will further impair already shaken balance sheets. The ECB’s initiatives then follows the steady deterioration of conditions in the European (indeed global) banking system which initially culminated in the coordinated action by global central banks to supply dollars through Fed swap lines and which found its European answer in the ECB’s decision to provide unlimited liquidity yet again.

The problems look ominous for European banks and the global financial system in general. No matter what, European financial institutions will have to delever significantly which will spread its tentacles wide and far due to the high penetration by European banks in emerging markets (Eastern Europe in particular). 

Behind the scenes however, significant ink has been spilled to debate and speculate on to the exact significance of the ECB’s liquidity operations.

John Hempton for example suggests that the ECB’s policy move is an open invitation to play the carry trade game using almost free liquidity to buy higher yielding government bonds. 

Well the Euro fix is in. Whether it works - that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.

I agree that the incentives are certainly there for the banks to play this game especially in the context of government bonds as zero risk weighted assets. The problem is that many European banks have spent more than a year and two stress tests to get rid of substantial amount of peripheral government debt (which do not count as zero risk weighted assets according to Basel III) and as such weak governments are unlikely to benefit from this. 

The flip side of this is that most of the liquidity taken up by banks go straight back to the ECB at the deposit facility which is now standing higher than at any time between 2008 and 2010. 

Quote Reuters

The euro zone banking system starts the new year awash with record levels of liquidity but few signs that institutions are prepared to lend to each other, leaving money markets frozen.Most of the near half trillion euros of three-year funds borrowed from the European Central Bank in the last week of 2011 have made their way back to the ECB's overnight deposit account.

The Reuters piece goes on to argue that most of the liquidity will probably go to aid the large refinancing need banks face in 2012 and thus effectively as a replacement for a non-functioning interbank market that would normally be able to roll this financing. If this does nothing to solve the problem of sovereign insolvency and illiquidity it will work wonders through the fact that banks won't act as a drag on their respective sovereign's balance sheet as long as the ECB is involved. 

I would note though that even though the liquidity is mainly reflected in reserves held at the ECB, it still represents excess liquidity as noted by Danske Bank. 

Some market commentators have argued that the first 36 months long-term refinancing operation (LTRO), in which banks took EUR490bn in total, has so far not worked as planned because the extra liquidity has simply been placed on the deposit facility at the ECB. However, this argument is false.The sharp increase in outstanding open market operations (MRO+LTRO) increases excess liquidity (defined as open market operations plus recourse to the marginal lending facility minus autonomous liquidity factors minus reserve requirements) and this excess liquidity shows up as deposits at the ECB in just the same way as it did in 2008-10. 

However, nothing is easy and despite the fact that collateral can be posted for liquidity the sovereign is still on the hook as my friend Edward Hugh points out. 

Banks are being encouraged to keep rolling over what are basically NPLs by financing them at 1% at the ECB (foreclosing on them in Spain and keeping the property on the books may cost something like 8% in comparison). But the ECB isn't assuming the risk here, the national sovereign implicitly is, and is getting in deeper by the day. 

This is certainly true by the letter of the law but one has to wonder whether the ECB will ever get paid back here. I mean 3 years is an awful lot of time. The ECB can roll these loans as long as need be (it has already effectively been rolling bank funding since 2008) while maintaining the figue leaf that it is not funding sovereigns. This may be true, but it is effectively funding the sovereign's banks and postponing the day of reckoning which is bank failures or nationalisation or both.

If the ECB is then forced take a hit on the collateral or the loans themselves, it will need to create the money to pay for these loans by printing euros. This sounds as a plan to me except that it does not solve the funding risks of governments which may or may not be able to ask their banks for help. The likely answer is that they won't be unless the ECB and EU decide to wield the ultimate weapon of financial oppression which would be to penalise reserves over a given level with negative interest rates at the same time as banks would be forced, through regulation, to hold government bonds. 

But Edward makes another interesting point;

Looking at the Greek PSI, what they would try and do (if all this gets that far, I mean if the Euro holds together long enough in this Byzantine world) ) is load up the private sector share of the haircut, and keep the ECB as untouchable official sector. At the limit they can use ELA to keep the banks afloat while the sovereign restructures and then recapitalises.

(...)

Why would any ex Eurozone third party want to be counterparty to anything which might end up being subordinated to ECB exposure later on down the line. The more I think about it the more it seems to me that the 3 yr LTROs might end up choking the European banking system to death.

It is difficult to disagree on the gist of this point, namely that the ECB is digging itself a very big hole. If banks can exchange under water assets at the ECB for a deposit asset at the ECB (albeit with a negative carry) the ECB is running the risk that it becomes the sole counterparty of bad assets in the euro zone in which case seniority will mean very little. 

The Greek situation is a good example. Private creditors face an almost certain 100% wipeout exactly because they represent such a small tranche of the total stock of debt. In such a situation the asymmetric relationship between subordinate and senior debt holders mean that the latter essentially become equity holders. But once subordinate creditors are wiped out the turn comes to the senior debt tranches and the further the ECB goes along the road of providing full allotment liquidity the higher will be its implicit direct claim on assets of all sorts of qualities.

In conclusion, it is my view that the ECB is now the only thing between the economy and widespread bank failures, but I also concur that the consequence of this is a permanent outsourcing of the interbank market in Europe to the ECB's balance sheet and, quite possibly, Fed's USD swap lines. 

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(1) - Even if such purchases have been fully sterilised. 

Random Shots - Fed Outgunned, EMU Outflanked

As I read the latest round-up of comments by Fed officials that they are certainly not ruling out another round of asset purchases I am wondering whether this signals another round of actual quantitative easing by the Fed or whether investors should change their mindset back to before the crisis where it wasn't the USD that acted as the global carry trade funder but rather the JPY (or maybe the GBP here?). 

Quote Bloomberg

Fed Vice Chairman Janet Yellen said yesterday that a third round of large-scale asset purchases “might become appropriate if evolving economic conditions called for significantly greater monetary accommodation.” A day before, Governor Daniel Tarullo said buying mortgage-backed securities “should move back up toward the top of the list of options.”

They join Charles Evans, president of the Chicago Fed, and Boston’s Eric Rosengren in calling for consideration of further stimulus to boost growth and bring down a jobless rate stuck around 9 percent or higher for 30 months. A stock-market rally and gains in manufacturing and retail sales may convince the Federal Open Market Committee, which meets Nov. 1-2, to decide that it’s too soon for a third round of bond purchases.

You see, the recent initiative of the Fed in the form of Operation Twist is not quantitative easing since it does not involve an expansion of the balance sheet. In stead, it is what we refer to as qualitative easing as the bonds the Fed intends to buy on the long end (to move long rates down to help the mortgage market) will be paid for by proceeds of selling bonds on the short end. 

The biggest problem for the Fed here is not necessarily that Operation Twist is a bad idea. Indeed, to the extent that it fixes the effort squarely on halting the slide in the housing market and supporting volume and price in the primary and second market for mortgage securities I think it is an excellent idea. 

But we are forgetting the auxiliary objective of QE by the Fed; to weaken the USD. Make no mistake that this is an important objective for the Fed even if they have never declared this formally. And herein lies the rub.  Quite simply, with the recent announcement by the BOE of another round of QE worth £75 billion, with the ECB now willingly or unwillingly being forced into increased support of peripheral debt markets and with the BOJ also pledging more stimulus, the Fed is starting to look like the conservative central bank in the G4. [1].

In my opinion, this is very significant and also one of the reasons why Fed officials are busy ensuring markets that they have plenty of ammunition left should economic conditions merit it. But investors should not take anything at face value I think. Before the Fed actually starts to buy those MBS and/or moves to lower interest rates on excess reserves there is a real chance that especially the JPY will start to act more like the JPY of old, a.k.a global carry trade anchor of choice. Of course, this requires the BOJ to back up all the pledges with real action. For now though, the only thing we can say is that the Fed looks set to be outgunned by its peers in the G4. 

EMU Outflanked 

Is Europe now finally getting down to serious business or is it just another round of fudge from the fudge factory that investors have learned to respect for its ability to produce relief rallies out of nothing. Looking at the evidence I am thoroughly inclined to go for the latter even if each failed attempt to shore up market confidence brings Europe closer to full fiscal union. 

Even if Merkel and Sarkozy, and rightly so, appear most concerned with putting pressure on Italy, the most significant issue remains Greece. The country is now in default, a fact that was un-sanctimoniously confirmed by the leaked bailout document which has the Troika admitting that the medicine they were mandated to administer would only make the patient worse and not better.

Quote FT

Greece’s economy has deteriorated so severely in the last three months that international lenders would have to find €252bn in bail-out loans through the end of the decade unless Greek bondholders are forced to accept severe cuts in their debt repayments.The dire analysis, contained in a “strictly confidential” report by international lenders and obtained by the Financial Times, is more than double the €109bn in European Union and International Monetary Fund aid agreed just three months ago. 

The most recent estimate of haircut has now risen to 60% and this, mind you, would only reduce the debt to GDP to 110% and this without any consideration on how Greece is supposed to grow itself out of this level of debt while simultaneously dealing with the default. In addition and only adding to my disdain for the ECB, Reuters reports that the central bank opposed a 60% haircut on account that it  the private sector would refuse likely refuse this leading to a "fullscale" Greek default. 

I am continuingly amazed by the denial here. Ever since the first Private Sector Proposal (PSI) was put on the table, Greek has been in default and figuring out who would pay for recapitalising banks as a function of how large the final haircut ends up are merely steps in the actual default process. 

The second issue on the table is what to do with the increasingly freakishly looking EFSF. There has been no shortage of suggestions on how to increase the scope of the fund using the same guarantee by the same countries for the same amount of money (currently €440 in effective capital). The suggestion that might actually work came from France which has aired the suggestion that the EFSF be turned into a bank which would then allow it to access liquidity from the ECB. Both Germany and the ECB however have vehemently denied this which indicates that there is still notable reluctance to allow the ECB to wield the full arsenal of quantitative easing. 

The proposal which currently seems to have most traction is to turn the EFSF into a monoline insurer which would essentially use its capital to insure anything from 10% to 30% on any new issuance of sovereign debt by Italy and Spain. Crucially, the idea is that this "leverage" would bring calm to markets as this insurance could cover as much as 2 trillion worth of debt. 

I really struggle to find adequate words here. I think this is madness and if any Eurozone politician were afraid that an equivalent of AIG would certainly enter the scene, they now seem content on creating one. The first and most widely flagged issue is this would obviously create a two tier bond market. 

Quote Reuters 

This would create a division between insured and non-insured debt, that could split a country's investor base and suck liquidity out of the market unless new bonds were carefully constructed to allow them to trade on a par with existing debt."The issuer would have to create a new curve of insured debt, limiting the liquidity in both curves with risks that investors would dump the old non-insured bonds," said Commerzbank rate strategist Christoph Rieger.

Based on a 20 percent insurance model, JPMorgan estimates that insured bonds issued by Italy would trade at a yield around 100 basis points below existing debt with new, insured Spanish debt likely to be priced 80 bps lower than existing bonds.

I think this is significant, but we are missing the main point here. If this is set ut Spain and Italy will likely never be able to issue un-insured debt again and the contingent liability here is not only complex but will lock in future capital commitments to this aim of providing first loss insurance. For me, this is a horrible way to spend already scarce capital. 

Another issue is obviously that it assumes that it will make the Spanish and Italian problem go away which it clearly won't. However, much more fundamentally; while the idea is to ring fence Italy and Spain it almost guarantees painful haircuts in the case of Ireland, Portugal and Greece and once again, who will pay for those I might ask. 

The only silver lining I have seen in the latest reports is that it seems to me that while the imminent obejctive is to fiddle with the EFSF, there has also been serious talk about bringing forward the ESM which would have a much stronger mandate and essentially constitute a first step towards socialising of sovereign risk in the euro zone. Until that happens, the EMU and her politicians will be continuously outflanked by economic realities. 

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[1] - I repeat that with the ECB not formally in ZIRP mode, the Fed still has the yield disadvantage here but do we really expect the ECB not to lower going forward? 

Random Shots - Down, Up or Sideways?

Of all the permutations of growth stories, scares and soft patches investors should remember that when all is said and done, the economy and market can only do three things; move down, up or sideways. Of the three, the last state is often the most interesting and challenging since while in such a state the debate will be centered on two main themes. Firstly, the reasons for said sideways movement that broke and otherwise upward or downward trend and secondly whether the market and economy will eventually will break this sideways movement by launching a new or resuming the old trend.

As far as goes the market's erratic movement in the first half of 2011 the immediate reason for the abrupt halt to the positive trend was the devastation of the earthquake in Japan and the subsequent (short term) slump of global equity markets. While the SP500 did have a sniff at new highs at the end of April and into May this level could not be held and we have since poodled back down below support levels.

One of the problems in the current environment is that while the immediate macroeconomic outlook is one of a slowdown, the question of whether it will turn into a more lasting double dip is more difficult to determine.

 (click on charts for better viewing)

On the face of it, we should now be approaching the point at which the global economy reveals to us just what level of growth that we can expect to be "normal" and crucially; where this growth is supposed to come from.

What might be starting to creep up on investors' screen is that the answer to the question above might not be what they anticipated.

On the basis of the data I am looking at, the upward momentum of global leading indicators peaked a year ago (in Q4-09) and momentum has since steadily declined to reflect growth returning to "normal" after the sharp recovery following the global financial crisis. The most recent soft patch in the middle of 2010 gave way to a rebound, but the key is whether the recent relative decline in growth momentum  is a messenger of a more sustained downturn or simply another so-called mid cycle soft patch. OECD's leading indicators point to a definite slowdown but also to a rebound towards the end of the year. The main point really is one of divergence between economies. 

In Europe it has become almost unbearably painful to watch the charade which surrounds the slowmotion default in Greece and the frantic attempts by policy makers to suggest that all is well and the next loan tranche is coming. Everyone can understand why politicians, of all people, should not give way to short term panic and whims of the market but we are way past the point of no return and we need a credible long term solution to not only Greece but indeed the debt overhang in the entire so-called periphery.

Not surprisingly, the macroeconomic backdrop of the ongoing fiddling while Rome (or was that Athens or Madrid?) burns is deteriorating. Morgan Stanley recently noted then that;

We see increasing evidence that the euro area business cycle has reached a turning-point. This verdict comes very clearly from our Surprise Gap Index, which plunged deep into negative territory in May. Our Surprise Gap Index is our long-standing favourite proprietary indicator to pick out the turning points in the euro area business cycle.

My only quibble would be that some economies in the Eurozone never experienced an upturn in the first place. It must now be clear for everyone that choosing to put faith entirely in a process of internal devaluation with little or no additional help from the ECB (and even interest rate hikes to boot) has put us in a situation which is far more dangerous than the one we set off from.

A sovereign default was always going to be costly and the main channel of transmission to the real economy will the capital shortfall at banks and who essentially should pay to recapitalise them. Yet, the continuing steadfast position that any form of restructuring is out of the question pushed us further towards the point where events overtake policy makers to such an extent as to foster a collapse of sentiment and trust which will ricochet far beyond the growing queues in front of Athens' banks.

In emerging markets, growth will remain strong but policy makers in key countries such as India and China have grown weary over inflation and especially in the former seems to be content on accepting short and perhaps even medium term slowdowns in order to tackle inflation. There is no risk of a recession in emerging markets (and thus the global economy) at this point but any slowdown in emerging markets will be an important litmus test for the developed world and thus just how dependent we may now be on a continuing expansion in the so-called developing world.

Even in the face of mounting inflation problems as a result of importing low interest rates from the US I remain constructive on emerging markets and especially on China. Quite simply, I am working under the assumption that while authorities may move clamp down on inflation and excess growth in credit the main bias is thoroughly towards letting the boom continue. If I see signs that this assumption may be wrong I will duly change my views, but so far so good.

But the real issue which may decide whether sideways movement in growth and market returns gives way to continued upside or renewed downside is what happens in the US and specifically, whether the Fed is readying a new round of QE3.

Priming the Pumps for a New Round of QE?

Bernanke is famously on record for linking success of QE to the ongoing strength in the stock market and while I have myself given support to this notion on the basis of simple empirical fact that the wealth effect seems to be increasing over time, it is the effect on the real economy we should rather be focusing on. John P. Hussman recently posed the following simple question;

My intent is not to argue strongly that the economy cannot continue to expand as fiscal and monetary stimulus comes off, but instead to at least ask why this should be expected as a foregone conclusion. On the basis of leading indices of economic activity, we observe more indications of economic slowing worldwide than we observe growth. Moreover, strong periods of employment growth have historically been preceded by high, not low, real interest rates. This is far from a perfect relationship, but it is clear that historically, high real interest rates are far more indicative of strong demand for credit, new investment, and new employment than low real interest rates are.

We will never know what kind of independent momentum the economy in the US (or elsewhere) is able to maintain without actually pulling back stimulus, but the question is whether now is the time to take the chance.

The question of further QE would seem to currently be a mute point. Almost all analysts I have been reading and the general message droning in off the wires of Bloomberg and CNBC is that QE3 won't happen. Recently, I watched a small clip in which chief economist at Goldman O'Neill simply noted that there wouldn't be QE3 because there was no need for it. In a recent post at his new blog my friend Edward Hugh also parses the entrails of the potentials of QE3 and while some analysts are beginning to pencil in the prospects of another round of QE it seems that it is a much more difficult call this time around.

For example he quotes a recent analysis by BNP Paribas;

“With equities, credit and commodities all continuing to trade in a range disconnected from weaker economic realities being transmitted via surveys, hard data and the interest rate markets, we arrive at the same conclusion as we have over the last month, primarily that financial assets are fully expecting further quantitative easing if the need arises”.

This would seem to be reasonable conclusion and essentially stipulates how the break down of any sideways trend would be contingent on whether the Fed decided to provide a further dose of QE. However, I reiterate that the general sentiment I get is that the current slowdown is different and that no further QE is needed. A lot here obviously depends on how believe inflation and inflation expectations to evolve. Edward quotes analysts noting that since the labour market is improving, core inflation edging up as well as inflation expectations taking off from sub-zero deflation territory QE3 is not needed. Yet, as I say, none of this is clear cut. Here is Edward;

Really I don’t buy these latter two arguments, and I don’t buy them for a number of reasons (I am not sure inflation expectations won’t be coming down, indeed I don’t see why they shouldn’t), but number one among them would be the danger of “event risk” in Europe. Basically it is important to understand the global mechanisms that are at work here, and the global implications of local decisions. If the global economy has been growing reasonably well over the last six months it is because what Nouriel Roubini once called a “wall of liquidity” is seeping out of the United States, where solvent domestic demand for credit is flat and will remain flat due to the private indebtedness problem (remember US “over consumption” (the high proportion of GDP which has been consumption driven) has only been the mirror image of Chinese “over investment” and we that live in a world which badly needs to rebalance).

This argument is interesting to consider in itself in the sense that it suggests how the mechanism by which carry trade flows funded in USD has been the main source of the incipient global recovery. The flipside to this argument obviously is that the continuing ultra loose liquidity adds considerable volatility to commodity prices which, in itself, is detrimental to growth. In addition, strong surges of headline inflation may also lead to stagflation which is evident e.g. in the UK.

The main issue however is that that the data in the US is turning sour and the housing market has not yet made it to the party. This week's job report was poor and, apart from an improving trade deficit, a faint hue of gloominess is returning to the US economy. But, are we looking at a real recession risk? The data I am looking at and the, after all, still positive momentum of leading indicators suggests no and I am moving in behind a general consensus. Hussman synthesizes the main position in his latest column;

In recent weeks, and particularly in last week's ISM, employment claims and unemployment reports, we've observed a substantial weakening in measures of economic growth. At present, the evidence of economic deterioration is not severe - as I noted in 2000, 2007 and last summer, recession evidence is best obtained from a syndrome of conditions, including the behavior of the yield curve, credit spreads, stock prices, production, and employment growth. While all of these components have weakened, they have not deteriorated to the extent that has (always) accompanied the onset of recessions.

So far, so good then. I would reiterate the point on the ISM indices which have turned decisively down lately with especially the manufacturing ISM shifting down considerably both in terms of the coincident activity index and new orders. The same goes for the non-manufacturing ISM although it eeked out a bright spot in May with an increase in the new orders component. 

The latest from Morgan Stanley's Gerald Minack also suggests that we should be sanguine on the US economy going into the second half of 2011 even if he merely postpones the deflation/growth scare 6 months. 

Investors again are worried about the expansion faltering. However, better second-half growth data – notably, in the U.S. – should help risk assets, particularly DM equities. The 2012 outlook remains problematic, however, with growth set to slow in most major blocs, bar the special case of Japan.

All this then seems to indicate that while the Fed certainly will be committed to low interest rates it might be more difficult for investors to genuinely expect a new round of full fledged QE3. This should also be seen in the context of the ongoing debate of whether QE works at all and whether the associated volatility in commodity prices is worth it. In his recent column Hussman puts his thumbs down; 

Rather, the policy [QE] has failed because it focused on easing constraints (bank reserves, short-term interest rates) that weren't binding in the first place. Very simply, neither the Fed's policy, nor the fiscal policy initiatives to date, address the central challenge that the U.S. economy faces, which is the debt burden on households.

This raises the central question of just what policy tools that should be applied in the context of a (global) balance sheet recession baring the case in which one simply lets the economy spiral into debt deflation and eventual widespread private and sovereign defaults. One obvious solution would be give some form of debt relief on a national scale and then let Fed re-capitalise the financial sector through equity or debt purchases, but just how much would be needed and what would this imply in terms of the Fed becoming an owner of capital rather than a custodian of the Greenback and its value. Besides, this solution has been tried in Ireland where it was merely the government who assumed a guarantee of its bad banks only then to have neatly forgotten the fact that monetary policy (and thus the ability to actually hone up to the guarantee through issuance of liabilities (i.e. currency)) had been ceded to Frankfurt a long time ago. The US naturally would be in a different situation but it would require the Fed to drastically shifts its QE towards private sector securities rather than government bonds. 

James Hamilton is also lukewarm regarding the end of QE2 for the same reasons as Hussman. The basic message is that QE2 has only had a modest effect, but also more importantly that the Fed can not be expected to exert much of an effect in the first place. While this may be true Hamilton does point us towards one key point which relates to the fact that although the Fed might not actually be starting off a new round of Treasury purchases, this does not mean that the Fed's balance sheet will actually shrink.  

A more technical issue then is another hotly debated question in relation to who the marginal buyer of treasury bonds will be once the Fed steps back from the fray. The interesting thing about the effect of QE is that while one would expect QE to help keep a lid on yields, the opposite has actually occured as e.g. QE2 has led to an increase in yields (which now looks about to reverse) on the back of the improving economic outlook. Conversely, one should then expect yields to go down (to reflect expectations of lower inflation?) as QE2 tapers off.

According to Morgan Stanley's David Greenlaw and absent the Fed as a marginal buyer the US Treasury will need, once again, to call upon an old faithful buyer. 

Given that Treasury issuance is expected to continue at an extremely elevated clip for the foreseeable future, how will the market adjust to the loss of most Fed buying?  In other words, who will be the marginal buyer of Treasuries going forward?  Our analysis suggests that heavy buying by the largest foreign holders of Treasuries will be needed to avoid a back-up in yields.

Indeed, on this reading the end of QE2 looks very significant indeed.

I would re-emphasize here that despite Greenlaw's main argument that there is little scope for further purchases by domestic actors a steadily deteriorating macroeconomic landscape should be bullish for treasuries all things equal, but I concur that without the Fed the market may start to get a little more attached to the supply side story. 

On balance it would then seem that the consensus remains weighed towards no QE3 either because it is not needed or because it does not work in the first place. I think it is very simple in the end though. If sideways movement gives way to a new downside in the market below key support levels it will be very easy for the Fed to argue for a new round of QE which I think they will deliver in due time. 

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* Intro picture taken from www.afewstrongwords.com.