OCTOBER 23, 2010
'QE2': How to Play the Fed's Next Big Move
As Expectations of Federal Reserve Bond Buying Build, Some Investors Are Betting on the U.S. Dollar and the Long Bond
By BEN LEVISOHN
Federal Reserve Chairman Ben Bernanke seems poised to deliver a second round of "quantitative easing," meaning the Fed will buy assets like Treasury bonds to lower long-term interest rates and boost the economy. Investors who pile in after the Fed could get hurt.
The central bank is expected to announce at its Nov. 3 meeting that it is launching the second round of quantitative easing since the financial crisis began.
If it works, the thinking goes, bond yields should fall, the dollar should drop and riskier assets like stocks and commodities should rise. That is what happened during the first round of quantitative easing, at the height of the financial crisis. The Fed's bond buying, which was first announced in November 2008, pushed stocks up 29.5% during the next 12 months, while gold gained 44.5% and high-yield bonds rose 16.6%. The dollar plummeted 12.6%.
But while Mr. Bernanke is widely expected to deliver on his end next month, the markets may not.
The problem is twofold. First, this isn't 2008. Back then the financial system was crumbling, asset prices and inflation expectations were depressed and Fed had much more wiggle room. The impact of its bond purchases could be felt more when 10-year Treasury yields were at 3.3% and inflation expectations were just 0.2% than at today's 2.5% Treasury rate and inflation expectation of 2.1%.
Boosting stock prices, too, was far easier when shares were trading at 666—the Standard & Poor's 500-stock index's March 8 intraday low—than it will be at today's 1180.
The full impact of another round of quantitative easing might have been priced into the market already, says George Goncalves, head of U.S. rates strategy at Nomura Securities International.
Mr. Goncalves cites the 10-year bond yield, for example, which has stopped falling despite accumulating evidence that the Fed will act. The yield fell from 2.92% on Aug. 6, when Mr. Bernanke's speech at the Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyo., persuaded the market that quantitative easing was on its way, to a low of 2.38% on Oct. 11. Since then yields have risen as high as 2.58%.
Other assets, meanwhile, have rallied. Since the end of August, the Dow Jones Industrial Average has gained 11.3%, oil has jumped 11.2% and gold has increased 7.6%.
"Investors who come to the table today have missed a big market reaction to the Fed's intentions," says Peter Boockvar, an equity strategist at Miller Tabak & Co. in New York.
Take the U.S. dollar. Currencies of countries with falling interest rates tend to weaken against those of countries with steady or rising rates. True to form, the dollar has dropped 6.6% against a basket of six currencies since Mr. Bernanke's Jackson Hole speech.
That decline, however, has been roughly equal to the increase in the money supply caused by the Fed's bond buying, suggesting the dollar has fallen as much as it should in the near-term, says Keith Hembre, chief economist at First American Funds in Minneapolis.
Shorting the dollar has been a favorite trade of some market professionals. Bets against the greenback by hedge funds and other speculative investors have more than doubled from $13.6 billion on Sept. 14 to $29 billion on Oct. 12, near the record of $36.5 billion reached in 2007, according to Commodity Futures Trading Commission data.
That leaves the dollar ripe for a short-term rally, says Nomura International currency strategist Jens Nordvig. He says the dollar index could gain 2% to 3% if the Fed announces an incremental approach to bond purchases, as investors who have shorted the dollar take profits.
Some contrarians even advise buying 30-year Treasurys. The long bond has weakened in recent weeks: Yields, which move in the opposite direction of price, have leaped from 3.53% to 3.94% since Aug. 26, the day before Mr. Bernanke's Jackson Hole speech. That has presented an attractive buying opportunity, says Richard Cookson, the London-based global chief investment officer at Citi Private Bank, especially if investors think the Fed's bond buying won't cure what ails the U.S economy.
"Unemployment remains very high, inflation is falling and quantitative easing isn't going to change that," says Mr. Cookson. Long-term interest rates, therefore, aren't likely to go up, and could even fall from here—meaning bond prices could rise.
A miniversion of the QE2-unwind scenario played out on Tuesday. After China announced it would boost key interest rates by a quarter-point, global markets convulsed. Stocks tumbled, commodities plunged and the dollar jumped. They all reversed course on Wednesday, as the QE2 theme that has driven the markets for the past two months reasserted itself.
But the trend could be near an end. Nomura's Mr. Nordvig, for one, recommends that investors own the U.S. dollar now, ahead of the Nov. 3 Fed meeting, in anticipation of a short-term rally.
"Expectations have gone too far," Mr. Nordvig says. "The magnitude of the moves is more than fully pricing what is reasonable."
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