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End of Easing: Get Ready for Higher Rates

Wednesday, 29 June 2011 06:54 AM

“Quantitative easing” has been a trendy term in financial blogs during the last three years. Quantitative easing, or "QE," is a sophisticated way to refer to "money printing" by a central bank.

QE consists of creating money and purchasing government debt or other financial assets to add liquidity to the markets.

The Federal Reserve has used QE to buy mortgage-backed securities, U.S. Treasury Securities, U.S. agencies’ debt and Treasury Inflation Protected Securities.

The Fed claims that it has engaged in the use of QE as a tool to support mortgage lending and housing markets with lower interest rates, to promote maximum employment and to maintain stable prices in the economy after a period of sharp economic contraction and financial turbulence.

This all sounds very nice, but QE has also been used as a mechanism in which the U.S. Treasury has access to "cheap" financing through the monetization of debt.

Since the financial crisis hit, the U.S. government has implemented a vigorous fiscal stimulus via deficit spending. By growing the government, the United States has been able to produce positive GDP growth while the private sector remains weak and contracting.

Since quantitative easing was formally announced on March 18, 2009, the U.S. public debt has grown by $3.31 trillion through May 26, 2011.

During this period until the end of June 2011, the Fed will have monetized $1.2 trillion in Treasury securities by the use of quantitative easing, monetizing about 36 percent of the $3.31 trillion of additional public debt that has been incurred to date.

At the end of this month, the Federal Reserve will finish the second leg of its quantitative easing program that was initiated back in November. The end of QE will most likely affect the capital markets and it is best to be prepared and be able to profit from the opportunities that the end of QE will deliver.

With the use of QE programs, the Fed has been able to cap interest rates in the Treasury market. By being a buyer of over a third of the debt, it has increased demand for Treasurys and allowed them to trade at yields near historic lows.

Despite that the public debt has increased by 30 percent since the QE programs started, interest rates have nominally increased about 1 percent from the record lows the 10-year Treasury hit during the financial crisis.

While the Fed hasn't been successful in lowering interest rates, it has been able to contain a sharp rise in them by buying more than a third of the mammoth amount of debt offered to the market by the U.S. government.

The expected fiscal deficit for this year totals $1.5 trillion, 9.8 percent of GDP and an increase of 10 percent of the U.S. public debt. With QE2 ending in just a few days, one would expect that interest rates should start to rise as the market will lose one of its main debt buyers and supply will keep on increasing.

Technically, if you look at the chart of the 10-year Treasury yield, you will observe that rates have bottomed at 2.85 percent. Yields are "oversold" and momentum seems to be shifting to the upside.

I also think that the dollar´s downtrend will soften and we will probably see a rebound in the greenback as it won't be debased by $7 billion a day. That was the amount of Treasurys monetized on average during QE2.

About the Author: Victor Riesco
Victor Riesco, a financial analyst and trader in Santiago, Chile, works as an independent adviser and educator and operates a brokerage and trading business for local investors. Click Here to read more of his articles.

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Quantitative easing has been a trendy term in financial blogs during the last three years. Quantitative easing, or QE, is a sophisticated way to refer to money printing by a central bank. QE consists of creating money and purchasing government debt or other financial...
Wednesday, 29 June 2011 06:54 AM
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