Unconventional Wisdom - Federal Reserve scare stories: Macquarie Research,

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Unconventional Wisdom
Federal Reserve scare stories
Event
 It is now just three months before the US Federal Reserve is scheduled to
end its latest round of unconventional monetary easing.
Impact
 The looming end of QE2 has triggered a round of scare stories about the
likely impact on both the US economy and financial markets.
 A lot of this analysis is based on claims that the termination of QE1 was the
trigger for a downturn in the US economy and a slide in equity markets.
 Such analysis does not survive even a cursory scrutiny. And putting in place a
strategy designed to capture a market shakeout after the end of QE2 is high
risk.
Analysis
 The Federal Reserve terminated its first round of major quantitative easing in
March 2010. Starting in late 2008 and expanding dramatically in March 2009,
this programme had a heavy emphasis on purchases of mortgage-backed
securities.
 Judging by the improvement in credit spreads, QE1 was a success. But there
were any number of commentators arguing that once the Fed stepped out of
the market, the mortgage-backed market would be in turmoil again. Well it
didn’t happen and this should be a cautionary tale for anyone anticipating a
disaster when QE2 ends.
 Of course the focus of QE2, which was authorised by the FOMC in November
2010, is purchases of Treasuries rather than mortgage-backed securities. So
this time there are fears that the absence of Fed buying will lead to a huge
rise in US government bond yields which would amplify the hit to the US
economy from the withdrawal of Fed liquidity support. One result of this
analysis would be a renewed downturn in US equity markets.
 The fact that the US mortgage-backed market did not fall apart after QE1 has
been largely ignored. Even though the trigger for renewed turmoil was absent,
the significant downturn in US equity markets in 2Q10 and the weaker US
economy towards the middle of the year has been blamed on the end of QE1.
It is also interesting that US government bond yields plunged despite claims
that it was only the Federal Reserve that was depressing yields.