Only a Wholesale Market Collapse Can Trigger QE3

The Fed’s monetary easing programs are getting smaller and smaller, and so are the chances of QE3. John Kicklighter of DailyFX. Only a collosal collapse could trigger action.

In the interview below, Kicklighter talks about QE3, the shape of Spain’s bailout, Japanese intervention and other topics.

John Kicklighter is a currency strategist for FXCM in New York where he specializes in combining     fundamental and technical analysis with money management. John authors a number of regular articles for  DailyFX.com, ranging in topics from basic fundamental forecasts for the G10 economies and commodities to more complex subjects like the level of risk sentiment across the financial markets and the carry trade specifically.    John has actively traded since he was a teenager. His experience ranges from spot currency, financial futures, commodities, stocks, and options on all of these instruments for his personal accounts. John graduated from the Zicklin School of Business at Baruch College in New York with a Bachelors degree in Finance and Investment.

If you look at the progress of the Fed’s stimulus efforts, a trend becomes immediately clear: smaller programs and with increasingly narrow focus. From shot-gun like TARP and TALF, we moved on to the large asset purchase program in QE1. From there, the Fed announced an equally sized QE2 that was tailored towards Treasury purchases. Then, we moved onto a $400 billion Operation Twist that would leave the balance sheet unchanged but lower longer-term rates. And, now we have a smaller extension of Operation Twist. There are many who believe the payoff from additional stimulus has diminished significantly with each program, and the central bank seems to be coming to the same conclusion. Unless there is another wholesale collapse in financial markets, it is unlikely that the Fed attempts a third QE effort – and even then, they could defer to a liquidity program instead of outright asset purchases.

It is unlikely that Spain will jump from its bank bailout to a full sovereign bailout. For most intents and purposes, there is little difference between the two. Spain’s government will still be responsible for the repayment of funds and even if they were given the capital, the bulk will still be put towards the banking system (very much like Ireland). This is a program in name, not structure – and policy officials no doubt expect this would be a good way to avoid the stigma tied to a full bailout. The long-term implications are the same, and the market is becoming skeptical enough that short-term sentiment could collapse as well. If investors aren’t in the mood to look through Euro officials’ rose colored glasses, it would just open the door to trouble ahead.

3. In the UK, the weak economy and inflation could justify more QE, but bond yields are very low, so such a move could have a limited effect. Will more QE be introduced? Or perhaps some different monetary stimulus?

The Federal Reserve has taken a clear tack in its policy to lower the long-end of its yield curve, but that isn’t explicitly the Bank of England’s effort just yet. When we compare balance sheets, the Fed has $2.87 trillion in assets and the ECB $3.72 trillion compared to the BoE’s $553 billion. That means there is still considerable room to play ‘catch up’ and inject funds directly into the system. That said, MPC members can see in other central banks’ efforts that policy is starting to reach its limits with investor confidence. Lowing the gilt rate is an economic effort, but at its current level, further declines are difficult to rouse as Euro-area risk aversion already accomplishes a drive lower. That said, the BoE minutes reported a 5-4 vote to keep the bond program unchanged, so it is highly likely a majority fills out next time – especially if financial conditions are still stressed.

Risk appetite trends were the key to the Aussie’s performance through June. With a bounce in capital markets, the demand for carry recovered.  Few other things could lift the troubled, high-yield currency. The fact that the interest rate outlook finally moderated from its aggressive 150 bps worth of cuts through 12 months forecast offers leverage to the positive risk bearing. That said, if risk aversion returns, a moderation in yield forecasts will mean little for a currency that depends on investor appetite.

The Japanese yen in the recent past has attempted to directly intervene during periods of explicit stress and in lulls when the market wasn’t expecting it. The common denominator was that neither reaction nor proactive endeavors had a lasting impact. The effort by the Bank of Japan to upgrade its asset purchases (and join the global central bank community of stimulators) was a graduation of effort away from the disastrous influence of direct intervention. They will not likely fall back onto the traditional method unless there is an absolute liquidity need. More likely, we will see the central bank and MoF attempt more unorthodox methods going forward.