Post-QE2 Expectations: Hybrid Market Activity, Rising Interest Rates, QE3?

Includes: GLD, TBT
by: Jose C. Ramirez

QE 2 ends in June, and the Fed Chairman, Ben Bernanke, has signaled that the 'run-off' from QE 2 will be re-invested back into treasury bills. The amount of runoff is estimated to be another $118 Billion in the next year ($36 Billion within 90 days, and $82 Billion within 91 days to a year), according to the Federal Reserve Statistical Release.

Here are the events that I see gradually unfolding: This is purely hypothetical and speculative, but I have yet to find a sound basis for an alternative theory.

1. QE 2 Ends, and the runoff is reinvested. At this point we can determine the strength of the treasury market absent, but lingering, the QE 2 Program. The result will be a 'hybrid' of market activity, in which the Fed purchases treasuries in conjunction with open market participants. The post QE2 auctions will invariable drive interest rates in the upward direction, as the lack of participation in treasury purchases, and hence demand for these securities is lower. This is evident by the mere fact that we have a QE2 program in the first place. Fortunately, we are showing positive GDP growth in the first quarter, unfortunately, this growth is anemic, as in the Q1 GDP is at about 1.8% annualized, which is well below the 4% expected trend.

2. As the demand for long term (10 year and more) US Treasury securities wanes, the interest rates increase at the right side of the yield curve. This side of the curve is the side that affects mortgage rates. The mortgage and housing market will continue to suffer from rising rates, feeding back into the economy as a negative input. In addition, the economy as a whole needs to absorb the higher rates, and this will add to the headwinds the economy already faces. Capital expenditures for longer term projects (read infrastructure) suffers as it becomes more expensive to finance these projects by both government and private sectors.

3. As the third quarter reports numbers in the fall of 2011, it may become evident that the higher interest rates are affecting the economy. The hope here is that the ample liquidity circulates in the economy, the velocity of money achieves full speed, so that while interest rates are a drag, M1-M3 money velocity provides a positive counter weight. This is critical, if the money that has been sitting on corporate balance sheets and banks isn't moving around and driving economic activity, Q3 may report a flat or less than 1% for GDP growth.

I see Q3 as the most important quarter we face this year in the way of economic activity, as a result of the expiration of QE 2.

Depending on the third quarter 2011 numbers, it will become evident whether a QE 3 program is warranted or unwarranted. Unemployment will most likely remain above 8%, so the specter of another recession may inspire another round of Quantitative Easing beginning in the first quarter of 2012.

The dollar may experience a temporary bump as the attraction of higher interest rates motivates investors to buy US Treasuries, but as the reality of anemic growth sets in, and the odds of a pending QE 3 program increase, another leg downard for the dollar is a distinct possibility.

There are the standard issues such as European debt crisis, high oil/gas prices, US fiscal policy, that could all derail a delicate recovery, and any of these issues alone is actually enough to justify a QE 3, after the economy begins to slow more.

Disclosure: I am long FHC, SBND, MO, JOF, IAU, PAYX, HOG.

Additional disclosure: I am short SLV. I may initiate a position in CORN in the next 72 hours.