THE BASIS POINT

Why Rates Could Rise if QE3 is Announced

Below is a QE3 report from Merrill today with more on the “sell the news” theme I noted a couple days ago. Rates rise when bonds sell, and if QE3 becomes real—meaning increased Fed bond buying starts—private investors may sell early on because they’ve already been buying ahead of the Fed up to that point. Which continues a “Buy what the Fed buys, only do it first” strategy PIMCO chief Bill Gross laid out when QE1 was getting underway.

If you look at this chart, you can see that rates rose (on MBS selling) after QE1 and QE2 were actually implemented. The rate rise was short term in both cases then MBS started rallying again (on various U.S. and European macro concerns), bringing rates back down.

For rate consumers, this all means that rates could rise immediately after any forthcoming QE3 announcement. However, if today’s ECB vow of stabilization falls flat and Europe’s issues worsen, that would temper any MBS and Treasury selloffs (triggered by a Fed QE3 announcement) and prevent rates from spiking.

Lots of uncertainty. Which means lots of bond/rate volatility. See link below on how to make rate locking decisions in this environment. But first, here’s the Merrill note:

As the economy sputters and downside risks grow, Fed officials once again find themselves contemplating further easing. In our view, the Fed will move when it is comfortable that the growth slowdown is likely to persist.

Likely next steps: forward guidance extension and QE3
We have revised our Fed call. We now believe that the Fed will extend its forward guidance to “at least through late-2015” on August 1, rather than through “mid-2015.” We also expect the announcement of a $600bn QE program in Treasuries and MBS on September 13, up from $500bn in our old forecast. We expect lower 5-10y rates in the near term and recommend fading any significant knee jerk back-up in rates on a QE3 announcement. We believe that QE3 will be much less effective than QE1/ QE2, both in terms of boosting risky assets and stimulating the economy.

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Also See:
Fed Moving Closer To QE3 – plus QE1, QE2 recap & timeline

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