QE3 Q&A

Seeing as tomorrow is the Fed's big day, I figured I'd briefly give my thoughts on QE3.

What will happen?
The market is expecting 'Operation Twist', whereby the Fed reinvests the maturing portion of their portfolio of short-term Treasuries (and MBS) into the long end of the curve, thereby lowering long term interest rates without altering the size of the Fed's balance sheet. Given their commitment to low-for-long the last time around (which guarantees that the short-end will remain flat), Operation Twist strikes me as the most reasonable policy expectation for this FOMC.

Will it happen?
I see this as about 50/50. While the Fed is looking to do more to stimulate the economy, the 5x5 year inflation expectations (the Fed's favorite measure of inflation) are much higher than they were at the initiation of QE1 and QE2. This gives them less cover when the politicians inevitably start harping on about currency debasement and the inflation that will follow (I personally do not see this as a likely consequence). It is important to remember the backlash from both sides of the aisle in response to QE2, which at the margin will make Bernanke more reluctant to act. On the other hand, unemployment - the other half of the Fed's dual mandate - remains unacceptably high.

Will it be effective?
With 10-year U.S. Treasuries trading at their lowest yields in 60 years, it is hard to imagine that Operation Twist, if implemented, will have a meaningful impact on the long end of the curve (25 or 50 bps at most). I am of the mind that the problem the United States is facing is a shortage of demand for credit, rather than supply (as Fed policy assumes). Therefore, I do not expect Operation Twist to have a measurable impact on the economy.

What will be the impact on asset markets?
This is a tougher question to answer, but it strikes me that Operation Twist is largely priced into asset markets. I suspect that commodity bulls will try to sell the QE1 and QE2 redux story - ie higher commodity prices, but since there is no net liquidity going into the system, I think the market will see through this. Selling the news is also a possibility here (but carries a considerably lower probability than the 'little marginal impact' outcome). Finally, given market pricing, should the Fed not implement Operation Twist, I foresee a significant sell-off in risk markets and the inevitable concomitant flight to quality. However, this flight to quality will be balanced by the sell-off in the long end, as people have bought in anticipation of Operation Twist. Therefore, I would expect the yield curve to steepen significantly.