Rathbones believes there is a very low probability of the US Federal Reserve implementing a third round any time soon, but this does not negate it from leaving the door open.
QE2 (whereby the Federal Reserve bought $600bn of assets to drive down long-term interest rates) was put in place last autumn due to concerns about a deflationary scenario, poor performance of some financial assets, stalling in the housing market, and wilting employment data.
Since its implementation, risk assets have advanced, but they did so from a low base and are now lacking direction. The Dow Jones, meanwhile, is currently on its longest losing streak since 2002.
At last count, CPI inflation for April was down on March, but only marginally, and inflation expectations were also falling, albeit well within a safe range.
Housing has entered a double-dip, with no major catalyst pending, and the figures remain disappointing, as testified by the most recent non-farm payroll figures (data showed that the US economy added only 54,000 jobs in May).
Overall, annualised GDP was just 1.8 per cent, but the official word is that this is a mid-cycle pause. Rathbones believes that the Federal Reserve is bumbling to find a more comfortable correlation between unemployment, housing, inflation and the QE mechanism.
However, the old arsenal (and old psychology of inflated sentiment inflating asset prices and thus investment) has diminished relevance, and this will become increasingly apparent as more variables enter the new equation that is today’s global landscape.
At this juncture, it is unlikely that the Federal Reserve will move in the near-term, and Rathbones believes that this is right, particularly while Japanese industry reclaims itself.
The path of commodity prices, however, is a more difficult tiger for it to cage. Meanwhile as Ben Bernanke, Federal Reserve chairman, has suggested, he’d rather hold onto existing asset purchases longer than buy more, thus maintaining lower rates for longer.
Things will need to get a lot worse in order for the Federal Reserve to implement another round of QE, such as some kind of "exigent" circumstance (its own words), the likelihood of which increases by the day, with a Greek default impending and China bailing out its local governments.
At that point, it will have no choice but to fall back on QE, simply because there’s no other viable alternative. The treasury market might well disagree and start to price in QE3 earlier, pushing yields lower. None of this addresses the real issue, of course – that all-important lending line.
Until a recovery is established in earnest, demand for credit is likely to remain paltry too. There are too many moving parts to contend with right now. If risk assets and inflation expectations start to wane, the Federal Reserve is in trouble. However, for now, it is a painful waiting game, albeit a very necessary one.
Performance of index over 1-yr
Source: Financial Express Analytics
Julian Chillingworth is chief investment officer at Rathbone Unit Trust Management. The views expressed here are his own.