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Fed Watch 2012: What Does Ben Have Up His Sleeve Now?

This article is more than 10 years old.

(Kitco News) - The U.S. Federal Reserve has pulled out all the stops in recent years, leaving the U.S. with a near zero interest rate policy since December 2008. With U.S. economic growth remaining lackluster, the debate rages on whether the Fed will embark upon another round of bond-buying in 2012, widely known as quantitative easing.

Current market rumors include expectations for a QE3 package of about $500 billion mortgage-backed securities.

The official monetary policy rate, or federal funds rate remains at zero to 0.25 basis points and the Federal Open Market Committee has suggested rates will remain at that level through mid-2013.

Traditionally, during recessionary periods, the Fed lowers rates, which encourages consumer borrowing and the increased levels of spending help drive the economy to stronger growth levels. That pattern isn't working this time. The massive consumer credit overhang from the binge spending of the 2000s has left individuals less eager to spend, especially given the rocky outlook in the labor market.

BETTER GROWTH AHEAD?

Recent U.S. economic data, however, has been surprising on the upside, leaving most economists to forecast a modest acceleration in GDP growth for 2012, and that has implications both for Fed policy and the direction of Treasury market yields.

Chris Rupkey, chief financial economist at the Bank of Toyko-Mitsubishi is calling for 2012 GDP growth at 3.2%.

"The economy may actually be lifting quicker than people expected. The weekly jobless claims number is a leading indicator, growth could be stronger than people expect," he said. In mid-December, the weekly jobless claims data dropped to a 3 1/2 year low, holding well below the critical 400,000 threshold for several weeks.

David Jones, president of the DMJ Advisors LLC, and a former Wall Street Fed watcher for 35 years, is forecasting 2012 GDP growth at a 2.75% rate. "With pent-up demand picking up there is some chance you get a little more strength."

Overall, Jones downplays the likelihood of a QE3. "The Fed is deeply divided over this and other issues. If we muddle through with the U.S. economy growing between 2 and 3%, I think it is unlikely we will get QE3. It will be a last resort measure that the Fed will leave on the shelf unless there is complete economic collapse," he said.

Josh Stiles, managing director at Ideaglobal went even further to warn that a QE3 package could result in more risks for the economy ahead. "Overall, the problems with the U.S. economy are not a result of interest rates being too high. I don't think the risks are justified with the perceived benefits of printing more money with QE3," he said.

Addressing potential risks of another QE package, Stiles said "it tends to create imbalances. To buy $500 billion in mortgages, printing more money on top of all the money they've already printed—it does tend to boost commodity prices every time they print money. That ends up hurting the middle and lower class Americans. Also, if we start to see the economy growing, [Federal Reserve Bank of New York President William] Dudley is wrong to say for the Fed to start unwinding that is no problem. "

Stiles sees Bernanke poised with his finger on the trigger. "I think Bernanke would be quick to do it [QE3] on any type of setback in the New Year. He will employ more options. But, every time he does it increases the risks of imbalances, bubbles and the difficulty of unwinding it without inflation."

Credit Suisse is in the camp forecasting a QE3 ahead. "we still believe that the Fed is preparing for a renewed round of large-scale asset purchases, this time focusing mainly on mortgage-backed securities… we expect it to begin before Operation Twist is completed in June 2012," wrote Credit Suisse economists in an Dec. 13 research note.

BOND YIELDS

Given the expectation that the Fed will keep official rates near zero, economists say that means Treasury rates will remain at multi-decade lows as well. The yield on 10-year Treasury notes has been on downward path over 2011, falling from near 3.75% in February to a low at 1.72% in September.

"That is a modern era low. It has been decades since we've hit these numbers," said Gennadiy Goldberg, fixed income analyst at 4CAST Inc. He forecasts a modest pick-up in 10-year yields towards the 2.50-2.75% near year-end 2012.

"For now, the whole structure of long-term rates is artificially held down by the Fed keeping its funds rate near zero and also as a result of the flight-to-safety from the Eurozone sovereign debt crisis," said DMJ Advisor's Jones.

Bank of Toyko-Mitsubishi's Rupkey expects to see "yields drift upward" in 2012 amid his expectations for stronger growth. He forecasts U.S. 10-year Treasury yields to hit the 3.4% level by year-end. "I think things will normalize. It is very abnormal for bond yields to trade below headline inflation. Also, QE2 ends in June. I think the safe-haven buying goes away," Rupkey explained.

With long-term rates at such historical lows, there is little place for them to go but up. Eventually, the U.S. economy will improve, sparking stronger inflation, the Fed will unwind the massive liquidity in the financial system and these factors will push Treasury yields higher. The question, of course, is when will that happen?

Ideaglobal's Stiles is only calling for a moderate 40-50 basis point increase in 10-year Treasury yields in 2012, with maybe a 20-30 basis point blip up for 2-year notes. Overall, "not terribly exciting," Stiles warns.

BOND DRIVERS

There are several unknown factors hovering on the horizon for bond yields, which include the Eurozone situation. An outright collapse in the Eurozone would most likely drive additional safe-haven buying into U.S. Treasuries—supporting a spike even lower from current 1.80% area.

Looking at a different scenario there is a risk that stronger-than-expected U.S. economic growth emerges pressuring longer-term yields higher than expected. "If growth exceeds expectations and we see the unemployment rate fall faster than the Fed thinks and we see a reduction in the risk premium from Europe, we could see a dramatic move in the long end," Stiles warned.

Finally, another factor, which will be key for the Treasury market in 2012, is so-called global risk appetite. During risk-off periods, global investors flock into the perceived safety of Treasury securities. Conversely, during risk-on episodes, investors pull out of Treasuries and reach for yield in more risky type of investments.

"If China achieves a soft landing from 10% growth to 8% and Europe just stalls or has a mild recession—if those conditions prevail we might get risk-on conditions, which would be consistent with a weaker dollar and less flight to safety, which would tend to push Treasury yields up," said DMJ Advisor's Jones.

Another longer-term structural black cloud looming over the U.S. Treasury market remains the huge budget deficit. "It is a critical issue for the bond market in terms of what happens on the fiscal side. And, fiscal discipline is a factor outside the Fed's purview. At the moment, the dollar is strengthening and U.S. Treasuries are benefitting from a flight to safety, despite our runaway budget," said Jones.

Bank of Toyko-Mitsubishi's Rupkey weighs on the issue. "With our deficit above one trillion, there is a risk that investors do pull back sometime. How will we come up with buyers?"

Shifting gears, Rupkey has an aggressive call for monetary policy. Given his more optimistic view on the U.S. economy than the consensus he is calling for a Fed rate hike in January 2013. "If near the end of next year, it looks like they will get ready to hike rates, we could see the 2-year notes go to 1.40%," he said.

Jones forecasts a Fed rate hike in the second half of 2013. "It is unprecedented for the Fed to be this easy, this long. The Fed has to think about working back towards normal."

Given the current outlook, 4CAST's Inc's Goldberg advises bond traders to simply: "play the range. It's going to be rangey price action. Traders could buy on the back-ups and sell when yields get uncomfortably low," he concluded.

By Kitco News; reporters@kitco.com