INSIGHTS

On November 05, 2010

Fed Announces Quantitative Easing

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With the mid-term elections transpiring into an even harsher repudiation of the first two years of policies for the new administration and frustration with the stagnation of the economic recovery, the Fed’s announcement of quantitative easing was somewhat discounted. Though the media was still digesting the historic change in the legislative and governorship controls, the Fed made a historic announcement of increasing Treasury purchases by $600 billion between now and June of 2011.

The markets response was dramatic; especially in the Treasury market as expectations for a greater amount and what maturities were to be purchased took them by surprise. Consider the movement intraday on the 30-year Treasury.

30 Year Intraday yield move Nov 3 2010

Source: Bloomberg. See Charts/Graphs Disclosure.

A 20 basis point sell off may not sound like much, until you consider it sold off from 100.25 at the 3.86% yield to 96.67 at the 4.07% yield, or simply put, a loss of 3.60% in the matter of an hour. This was the direct result of the announcement that the purchases were going to be in the 5-10 year range of maturities and not further out.

Another aspect which potentially magnified the move was the day’s economic releases which surprised many on the positive side.

• ADP employment change came in better than expected with a rise of 43 thousand; expectations were for a rise of 20 thousand.
• Factory orders rose 2.1% from last month’s decline of –.5%. Orders were better than expected with a rise of 1.6%.
• ISM non manufacturing (service sector) came in at 54.3 versus expectations of 53.5. Any reading over 50 is expansionary and the 13 year average is 53.7.

Some pundits were expecting a much larger and ambiguously timing of the purchases in the Fed’s announcement. In some instances, the amounts being thrown around would have made the amount of Fed’s Quantitative Easing purchases larger than the net new issuance of Treasuries.

One should note that when the Fed embarks on purchases such as this, it actually becomes an interesting accounting transaction. On one side, it increases its assets by purchasing Treasuries, while it is offset as a liability for dollars. It may seem trivial, but it has all the complexity of how net trade impacts capital and current accounts.

Consider the Fed’s Balance sheet’s rise over the last 17 years and as a % of GDP.

Fed Balance Sheet

Source: Federal Reserve, Bloomberg. See Charts/Graphs Disclosure.

What one should notice is not only the drastic increase at the time the credit markets froze, but that the purchases were steadily rising over the last 17 years in almost direct proportion to GDP growth (as designated by the near zero growth in the Feds total securities held as % of GDP).

Don’t fight the Fed is once again a mantra that we believe is a wise strategy. However, you have to differentiate which action not to fight. If you purchase Treasuries along with the Fed, we believe you are getting a longer term reward less risk. We believe the ramifications of the Fed’s move is the more important strategy. We believe they will be successful in inflating assets and the economy and thus being only short term holder of the assets they are purchasing. Where the Fed traditionally lags in stimulating the economy with lower rates while the turnaround was already in place, we believe it will occur again with the QE taking over the role of interest rates.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.