SocGen - QE 2, a fire drill and preparations for the real thing

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9 August 2010

EconomicsBeyond the Cycle

www.sgresearch.com

American ThemesQE 2, a fire drill and preparations for the real thing

Stephen GallagherChief Americas Economist(1) 212 278 [email protected]

Aneta MarkowskaUS Senior Economist(1) 212 278 [email protected]

Martin RoseResearch Associate(1) 212 278 [email protected]

Fidelio TataHead of US Rate Strategy(1) 212 278 [email protected]

Fed Chairman Bernanke in testimony before Congress in late July stated that the Fed wouldtake additional steps to support the economy as needed. In follow-up he offered further stepsthat may be helpful but difficult to describe as aggressive. His FOMC colleague, St Louis FederalReserve President James Bullard has argued in favor of more aggressive action, additionalQuantitative Easing (QE), if the risks of deflation intensify. Conventional Wisdom When Bullard proposed a more aggressive second round ofquantitative easing the first questions were: what would the Fed purchase and how would that

influence the market? Our immediate response - and it seems the markets response - is to

believe the Fed would purchase Treasury securities along the yield curve, rather than purchase

additional mortgage-backed securities. The Treasury curve would be mostly biased to flatten,

but there would be limited interest in the long bond. It is striking that prior to any announced

new QE program, the market already seems to be trending along these conventional lines.

Additionally, the liquidity offered would support most assets and likely weaken the dollar. That

market is trading on hopes for more QE. There may be danger in this conventional wisdom. An

announced QE program may continue these trends further, at least initially. What are the

pitfalls of conventional wisdom? Too often there are many.

Implicit assumptions behind initial market performance and what may be wrong. 1. The biggest and perhaps the most dangerous assumption is that QE will not have much

success initially in altering inflation expectations. Suppose that investors viewed the Feds

new QE program favorably. Expectations for the economy could rally. Bond yields could

go up. Eventually a successful Fed reflation effort could drive yields notably higher with

the question being, when will inflation expectations turn more constructive?

2. The second assumption is that short-term yields near zero cannot go much lower and thatadditional Fed purchases would drive all yields toward zero and therefore flatten the

curve. This thought is recognizing the introduction of a new Treasury buyer with deep

pockets and long staying power. Does it miss, however, the opportunity for currentowners of Treasury securities to unload when a large buyer is active? A few funds, and

foreign investors, could be looking to sell into any purchase program, particularly if the

QE program is viewed as possibly succeeding.

The announcement and initial rounds of Treasury purchases by the Fed would lower yields

and flatten the Treasury curve. This is more due to a zero-bound constraint and the already

distant market expectation for rate hikes by the Fed. This scenario already priced in the

market - implies that inflation expectations are stable or falling. The high risk here is that once

the market perceives potential success from QE for the economy, inflation expectations could

rebound swiftly.

Table of Contents:

What would the Fed want

to accomplish with a new

QE round? Page 2

The important role of

inflation expectations

Page 3

Executing further QE if

needed Page 4

The Fat-Tail Scenarios

Page 8

This document is being provided for the exclusive use of MARTIN ROSE (SGCIB)


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9 August 2010

What would the Fed want to accomplish with a new QE round?The end goals are easy. Faster growth, lower unemployment and a stable inflation rate

between 1.5% and 2.0%. Reaching those goals via QE is not as straightforward. We see three

desires the Fed might hope to achieve: lower rates, raise inflation expectations or alter the

slope of the curve.

1. Lowering rates. The Fed can have significant influence on rates for any instrument itchooses to buy. The Federal Reserve is most likely to purchase Treasury securities

(see below for further comment). The Fed can simply buy large quantities to drive the

price or yield to a desired level. This may not help the economy. Market rates on

corporate and mortgage debt would in time widen to the Treasury curve the further

Treasury yields moved from fair value. Also, non-Fed holders of Treasuries would

over time sell over-valued securities.

2. Raising inflation expectations. Inflation expectations are a highly signif icant variabledetermining outright inflation. Deflation episodes require expectations of falling

prices. Anchored and positive expectations are the most desired outcome. Raising

inflation expectations could raise market interest rates. Market rates are comprised of

real interest rates plus inflation expectations. Real rates could fall. They seem to be

near zero already, but real interest rates can and have fallen below zero. The Fed can

lower interest rates across the curve if it buys sufficient amounts of Treasury

securities. If inflation expectations rise, the Fed may find itself the only buyer of

Treasury securities and nearly all other interest rates would widen to the Treasury

curve. These are extremes, but need to be thought out. Ultimately, monetization

becomes a worry that raises serious inflation concerns. In Japan, monetization hasnot led to inflation. We will be examining this issue more fully in later writings.

3. Altering the slope of the curve.The Feds Open Market Desk does not on its ownvolition take actions to alter the curve. That would be a policy choice. The FOMC

could charge the Feds Open Market Desk to embark on such an approach, but this

has been very rare. We show below how the Fed has purchased securities in the past

in a manner intended to be curve neutral. A heavy buying program of Treasury

securities when the short-end is already near zero, however, could readily impact the

curve.

The Feds key motivation is to fight deflation and its fear is that inflation expectations could

slip and even turn negative. That would be the recipe for serious deflation. Hence raising

inflation expectations or at least preventing a further drop of inflation expectations is how we

see the Fed progressing.

So far, and initially, inflation expectations are low and could fall before rising. New policy

stimulus, particularly QE, would have more influence on the supply/demand for Treasuries

(removing supply available to the market) without much change on inflation expectations. This

may not hold long. Signs of success in the Feds efforts would eventually raise inflation

expectations. We saw this transpire in the market in mid-2009 as the economy began to

strengthen. Governments have not seen much change in their borrowing costs, although

municipal yields failed to follow Treasury yields down over the past month.



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American Themes

9 August 2010 3

The important role of inflation expectationsThe self-fulfilling nature of price expectations is a serious threat for both high inflation and

deflation.

10-year Treasury yields were well below 3% in the US at the end of last week, following

economic news as well as Bullards comments about QE. See mingly, this is due to falling

inflation expectations. Bullard tied the increasing risks for deflation to low inflation

expectations. What are current inflation expectations? There are different measures, but

generally all are sliding. Our models for inflation depend heavily on inflation expectations (See

American Themes, Labor market slack and the growing deflation risk, March 2009).

Deflation, a sustained price decline, needs falling expectations.

Current measures show softening inflation expectationsThere are three sources of information about inflation expectations: surveys of consumers,surveys of inflation forecasters and the market for Inflation-indexed bonds. Economists

inside and outside the Fed look at all three measures. Rather than precision on the number,

policy making is formed via direction or movement of expectations.

1. Consumer surveys. The most popular is the University of Michigan survey thatoffers both short-term and long-term expectations. The consumer survey can be

susceptible to gasoline prices. On the good side, these expectations have been

surprisingly accurate.

2. Professional forecasters. There are many surveys. When the Fed sources privateforecasters it cites the blue-chip economic forecasts. Surveys done by the Wall

Street Journal or Bloomberg can be easy substitutes. In our models of long-term

inflation that incorporate inflation expectations, we use the Philadelphia Federal

Reserve Survey of Professional Forecasters because of its long-term compilation.

3. TIPS market. Economists and Fed officials know the data is flawed by liquidity. The10-year TIPS benefits from a liquidity premium relative to other TIPS issues. The Fed

publishes an adjusted TIPS inflation forecast that can be found on Bloomberg and

charted on the left. Brian Sack, head of the Feds Open Market Desk in New York,

was one Fed official behind the method to adjust for liquidity. Fed analysts may have

their own methods for interpreting the basic break-even inflation rate (BEIR) in the

TIPS market, but all generally know the basic BEIR. It is movements rather than

precise levels that generate concern. The basic BEIR is slowing more than the

inflation adjusted. Either the premium for 10-year TIPS is improving relative to other

TIPS issues or the adjustment is failing to capture the drop of inflation expectations.

The Fed and private analysts need to look at both without overweighting one.

Overall inflation expectations are softening. Short-term expectations are seeing a more

pronounced decline since energy prices have recently softened. Energy prices and other

commodity price are enjoying a renewed upswing. Rising oil prices again above $80/bbl

should lift headline data. Long-term inflation expectations have been more anchored.

Inflation Expectations MeasuresConsumer Survey (UM)

0

1

2

3

4

5

6

02 03 04 05 06 07 08 09 10

%

Inflation Expectations 5-10yrs

Inflation Expectations 1yr

Professional Forecasters Philadelphia Fed

0.0

0.5

1.0

1.5

2.0

2.5

3.0

02 03 04 05 06 07 08 09 10

%

1-yr Survey Prof Forecasters

10-yr SPF

TIPS Break Even and FedAdjusted 5yr-5yr forward

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

05 06 07 08 09 10

%

Implied byTIPS

Implied byinflation swaps

Sources: Global Insight, Bloomberg and SG

Cross-Asset Research

http://www.sgresearch.com/p/en/3/0/2321/9B78010C46718CFFC125757C005BCF2B.html?sid=a4aa9afc7ceadbd9c133c150411013b7http://www.sgresearch.com/p/en/3/0/2321/9B78010C46718CFFC125757C005BCF2B.html?sid=a4aa9afc7ceadbd9c133c150411013b7http://www.sgresearch.com/p/en/3/0/2321/9B78010C46718CFFC125757C005BCF2B.html?sid=a4aa9afc7ceadbd9c133c150411013b7http://www.sgresearch.com/p/en/3/0/2321/9B78010C46718CFFC125757C005BCF2B.html?sid=a4aa9afc7ceadbd9c133c150411013b7


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From March 2009 to November 2009 when the Treasury purchased $300 billion of Treasury

securities it purchased across the yield curve. The Treasury purchased greater amounts at

shorter maturity levels and generally aimed to duration-weight the purchases to neutralize

their impact on the curve.

The charts below show recent Fed purchases of Treasuries by maturity. The chart on the left

shows the notional amount of Treasuries held in various maturity buckets of the SOMA

portfolio. It appears that the portfolio is front-loaded with comparably larger positions in

shorter-dated Treasury securities. However, the duration of those short-dated securities is

smaller than the duration of longer-dated securities. Thus, the curve impact is different across

the curve for purchases of equal amounts. To normalize the curve impact we multiply the

position values by their respective DV01 (Dollar value of a basis point change in yield). The

result is shown in the chart on the right.

It is quite obvious that the SOMA portfolio is very well balanced with respect to the curve

impact on different parts of the yield curve. A similar DV01 for each maturity bucket implies

that the curve impact of the purchase (and a possible liquidation in the future) is

approximately the same across maturities. Put differently, the SOMA purchases were

weighted to cause parallel yield curve movements. They are basically curve-impact-neutral.

2009 Fed purchases of Treasury securities. Dollar value of a basis point change

50

100

150

200

250

less than 2years

2-5 years 5-7 years 7-10 years 10-15 years 15-20 years 20-30 years

USD bnRemaining Maturity of Treasuries held in SOMA Portfolio

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

less than 2years

2-5 years 5-7 years 7-10 years 10-15 years 15-20 years 20-30 years

USD DV01 of Treasuries held in SOMA Portfolio

Source: Federal Reserve, SG Cross Asset Research The Treasury data is charted by looking at their remaining maturity and not the original issue maturity

Influence on the yield curveThe Feds intent may be neutral but the purchases can have a strong influence on the curve

nonetheless. Markets constantly re-assess the economic forces and Fed rate projections.Initial purchases may coincide with the market pushing out further to the future its

expectations that the Fed will raise rates. Additionally, these actions may increase confidence

that the economy will rebound. Inflation expectations might rise. These factors would steepen

the yield curve.

The expectation for a flatter curve - at least immediately on the prospects for further QE - is

based on a belief that shorter-rates are near zero and are zero-bound. At an extreme,

purchases that drive the entire curve toward zero would flatten the curve at that one level.

This thinking may be dangerously simplistic. At some point, the market should gain

confidence that the Feds efforts to restore growth and support inflation expectations are

succeeding. At that critical juncture, the Treasury yield curve should steepen.

Historical information is thin, but the recent Federal Reserve and the Bank of England

purchases offer some insight.



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American Themes

9 August 2010 7

Government yield curve moves following CB purchasesWe examine in the charts below the slope of the Treasury and the Gilt curve following

purchases of government debt by the Federal Reserve and the Bank of England. There are

similar steps

Treasury yield curve slopes during Feds QE program Gilt curve slopes during BOEs QE program

0

50

100

150

200

1/09 3/09 5/09 7/09 9/09 11/09 1/10 3/10

bps

US Treasury Spreads

2Y-5Y 5Y-10Y 10Y-30Y

Announcement

Program

completed

0

50

100

150

200

250

1/09 3/09 5/09 7/09 9/09 11/09 1/10 3/10

bps

UK Gilt Spreads

2Y-5Y 5Y-10Y 10Y-30Y

Announcement:75bn

Programc

ompleted:

200bn

+50bn

+50bn

+25bn

Source: Federal Reserve, Bank of England, Bloomberg and SG Cross Asset Research

In both the Fed and the BoE examples, the commencement of QE steepened the curve,

particularly in the short-to-mid coupon sector. This may have coincided with a major re-

adjustment of Fed and BoE rate expectations for the future. The announcements of these

programs should have given the markets reason to believe central banks would keep rates

lower for a much longer period of time.

In contrast, for the long-coupon spread here measured from 10-yr to 30-year in both

cases the announcement and purchases induced some narrowing or flattening at the very

long-end of the curve. The narrowing spread between the 10-year and 30-year is less

pronounced in the US than in the UK.

For the US, after some initial steepening in the first few months of the purchase program, the

curve stabilizes. At the end of the program, as the economy was gaining traction in late 2009

and early 2010, the curve steepened, particularly in the 5-10 year sector which may have

leaned more on rising inflation expectations and projections that for the near term the Fed

would remain on hold.

Curve for the future in another round of QEThe market has already priced in an extended period of unchanged policy by the Federal

Reserve. The 2-year note is already at all time lows near 50 bps. Another 25 bp drop could

take place if the Fed signals a more prolonged period of low rates. The 10-year and even the

30-year have scope for larger absolute yield declines. It is mostly for this reason we expect

the curve to flatten further. This would be true for the 5-10 year sector and the 10-30 year

sector of the curve. These may be the initial moves. As the program completed and investors

turned more confident on the economic outlook, the 10-year to 30-year spread in both the US

and the UK steepened.



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9 August 2010

Recent activityUS Treasury yield curve more recently

0

50

100

150

200

250

300

350

400

Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10

Basis points

10-yr 2 yr

30 yr -10 yr

30 yr -2yr

Source: Bloomberg, SG Cross Asset Research

More recently, as the economy began to show signs of losing momentum and as speculation

on further QE from the Fed gained serious traction, the 2-year to 10-year sector of the

Treasury curve flattened. This might be due to the zero-bound constraint on the 2-year.

Although still above 50bps, the zero-bound may be increasingly important.

The 30-year yield however is widening to the 10-year. This might be explained by 1) higher

very long-term inflation expectations, 2) the market does not expect aggressive Fed

purchases in the very long end of the curve, or 3), the 10-year sector is benefiting uniquely,

perhaps for liquidity reasons. In regards to the Fed purchase sizes, we have heard various

officials express concern about holdings of long-term securities and the difficulties they

presented for exit strategies. The reinforcing message, however, of our current analysis is that

the Fed will remain duration neutral across the yield curve.

The fat-tail scenariosA. ENDGAME HYPOTHESIS The automobile and banking industries have survived the

meltdown and housing will eventually stabilize. This could be the last push of the

"hedge fund Fed" to load up on Treasuries and mortgages. With less liquidity among

the other market participants (hedge funds side-lined, bank prop-desks' wings clipped

by regulation, Asia in wait-and-see mode etc.), this creates a historic opportunity for

holders of TSY securities to cash out. Thus, the Fed buying could well be immunized by

an equal amount of (motivated) selling from money managers, foreigners etc.

B. YIELD CURVE HYPOTHESIS An inverted yield curve does not make the Fed lookgood. Inverted yield curves have been associated with the recessions of 2000, 1991

and 1981. The curve also inverted in 2006. Because the Fed needs to hike front-end

yields eventually, the Fed probably prefers a steep yield curve so that the curve does

not invert right away (and signals another recession). Also, a steep curve creates

income for financial institutions, which became junkies to the easy-money environment

of the Fed and may react adversely if the curve inverts. Thus, the Fed will likely try to



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American Themes

9 August 2010 9

avoid a yield-curve-flattening. We remarked earlier that the Fed is neutral on the curve

unless directed by the FOMC. The watch here would be that the FOMC issues an

historic directive.

C. CORPORATE ISSUANCE HYPOTHESIS August 2nd was the third-largest day ofcorporate issuance in 2010. IBM issued a 3-year with a 1% coupon, which is the lowest

coupon for corporate deals ever. Take-away: corporate issuance makes sense from the

issuers' perspective. This creates a huge liquidity pool for investors willing to switch

from TSY into corporate credit. Liquidity/supply attracts buyers (eventually) and there

could be a massive switch from TSY into credit on the horizon. The swap curve trades

through the TSY curve for 10+ years, so there is plenty of room for corporate securities

to cheapen (while issuance picks up) while remaining attractive from an issuer's

perspective.

D. TREASURY RISK HYPOTHESIS Treasury instruments used to be considered theclosest proxy for being risk free. A number of recent developments question this

assumption. First, swap spreads turned negative, first for 30-year and then for 10-year.

One explanation is that holding a Treasury (and financing it in repo overnight) is now

considered more risky than receiving on a long-dated swap. In a swap there is virtually

no counterparty risk as the notional is not exchanged. There is no financing risk. The

swap curve is smooth and not subject to QE-implied volatility. Second, short-dated

implied volatility on Treasuries now trades at a premium over short-dated volatility on

swaps. That used to be the other way around (because swap spreads used to be

directional, amplifying a move up/down in interest rates). Now, 3-mo-into-15yr TSY vol

trades about 10% over the equivalent swaption vol. Risk-adjusted Treasury yields don't

look as attractive as they otherwise would be compared to credit curves and this could

accelerate a possible move out of Treasuries (similar, maybe, to the move from CMT

into CMS in the 80s).

ConclusionsThe Fed is watching inflation expectations and is fearful that, if expectations fall, deflation

could ensue. Given the low level of inflation and inflation expectations against the soft

economic backdrop nearly any major shock could substantially lower inflation expectations. In

such a case the Federal Reserve would very likely adopt a second-round QE program.

The next round of QE would more likely consist of Treasury securities instead of mortgages.

The announcement and initial rounds of Treasury purchases by the Fed would lower yields

and flatten the Treasury curve. This is more due to a zero-bound constraint and already

distant market expectation for rate hikes by the Fed. Further, this expectation implies that

inflation expectations are stable or falling. The market is already pricing in such a scenario.

The high risk here is that once the market perceives potential success from QE for the

economy, the inflation expectation could rise swiftly. There is greater chance of this turn in

comparison to Japan where low inflation and inflation expectations remained intact. Further,

we would be wary that major Treasury holders sensing success of the QE plan would use the

Fed buying program to unload.



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9 August 20100

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