According to many economists and financial industry insiders, the Federal Reserve likely will announce a third round of quantitative easing (QE3) tomorrow. But Larry McDonald, senior director for credit, sales and trading at Newedge, believes that the Fed will — and should — postpone QE3.
In a new analysis, McDonald says that the potential rewards of QE3 — namely increased job creation — are not enough to justify its risks. And although speakers at the Democratic National Convention credited President Obama with the creation of 4.5 million private sector jobs, McDonald cites a CNN.com report that estimates the economy has created a net total 300,000 non-farm payroll jobs since the depths of the recession. “Even under the rosiest review,” McDonald asks, “some beg the question: Is 4.5 million jobs really worth an extra $2 trillion Fed balance sheet risk?”
One major risk of QE, according to McDonald, is potential loss of liquidity in the domestic bond market, traditionally a strong market for the U.S. “The one thing that we have in the U.S. that’s kept a good bid on our bonds in the public market is the deepness and the liquid nature of our bond market,” he says. “The evil thing about QE, if they do it again, is that it’s making our bond market less liquid and less deep because the Fed is holding so many bonds.”
He also worries that pension funds, which he says own $842 billion in U.S. Treasuries, will suffer if interest rates rise. “A $143 billion loss on top of an underfunded pile of pensions is the last thing we need,” he says, “but that's the pain with a 2% move higher in interest rates.”
Finally, McDonald says that the Fed needs to “keep the powder dry” in light of the impending “fiscal cliff” and the Eurozone debt crisis. “Why shoot your bullets now when Spain is on the verge of almost depression and Europe’s been back and forth in terms of good news-bad news?” he asks.
McDonald compared recent actions of ECB President Mario Draghi to actions taken by former Treasury Secretary Hank Paulson and the Federal Reserve in 2008 when Bear Stearns faced insolvency.
McDonald points out that the various liquidity facilities created by the Fed after the bailout — that had JP Morgan buying Bear at a discount with the Fed on the hook for nearly all the toxic assets held by Bear — had the effect of allowing Lehman Brothers to carry on its irresponsible ways. “It gave Lehman access to credit,” McDonald says.
Fast forward four-and-a-half years and Draghi unveils a bond buying program that effectively lowered the rate of Spain’s 10-year notes from 7.56% to 5.68% according to McDonald. But now that the rates have dropped Spain is balking on the bailout because they say don’t need it and do not want to come under the supervision of the European authorities the way that Greece is.
McDonald fears a similar fate but expects that if Spain does not accept the bailout, their rates will return to previous levels. “Spain is being cocky,” McDonald says.
More disturbing to McDonald is just how much our markets are being affected by the various Eurozone machinations.
He notes that Spain has not even completed stress tests, comparing it unfavorably to the way Ireland — who last month reentered the bond market — has worked through its debt crisis.
“Ireland [is] coming back to the capital markets as Spain is heading for the exits,” McDonald notes. “Somebody took the pain, while somebody else has put it off.”
McDonald is not as sure are other analysts are that QE3 is coming and he distinguishes what the U.S. Fed has done with efforts in Europe. “Quantitative easing for the last two years [is about] allowing the Fed to impact employment when interest rate levels are exhausted — in Europe it is about buying Spanish bonds when the market won’t.”
He adds, “This is a classic moral hazard moment.”
As for the Fed, McDonald concluded, “I say no QE3 for now. They'll keep the powder dry; it looks like they're very close to table max.”