Antoine Gara

Assignment 8

Markets React Quietly to Well Communicated Monetary Easing

With traditional options exhausted, the Federal Open Market Committee

concluded its monthly two-day meeting by announcing its second asset purchase program
since the onset of the financial crisis. It will buy 600 billion dollars of Treasuries by June
2011 at a pace of 75 billion dollars per month to promote a stronger pace of recovery in
the face of what it described as a slow recovery in economic activity and employment.
The Federal Reserve will also reinvest up to 300 billion dollars of repayments on its
portfolio assets into treasuries at a rate of 35 billion dollars a month, pushing its total
buying up to 900 billion dollars.
Since Federal Reserve officials broached the subject of easing last August, US
markets rallied strongly; however muted reaction after the announcement illustrates good
advance messaging by the Federal Reserve.
In its statement, the Federal Reserve pointed to concerns over slowing inflation,
business spending, and housing starts as cause for its decision to purchase treasury assets
through June 2011. The only vote against easing was Kansas City Fed Governor Thomas
M. Hoenig who believed the risks of unstable long-term inflation and future financial
imbalances outweighed the benefits of additional securities purchases.
Attached to the FOMC statement was an announcement by the New York Federal
Reserve that 66 percent of total purchases in the program would be made between 4 to
10-years in duration, with an average purchase duration of 5-6 years. Middlebury College
Professor and former Vice President of Foreign Operations for the FOMC Scott Pardee
particularly liked "that the New York Fed dispensed the actual numbers of its purchases."
He believes the New York Fed disclosure is a smart way to "prevent bubbles in certain
treasury securities."
After the announcement, markets had a mixed reaction showing that Fed action
was slightly greater than already priced expectations. Two-year treasury yields fell below
0.34 percent while 10-year yields rose and the 30-year yield climbed above four percent.
Equities, which were negative prior to the announcement rallied into modestly positive
territory. In the currency markets, the euro rose above 1.41 versus the dollar, while the
Australian dollar broke above parity against the dollar for the first time since 1983.
Sebastien Galy Chief Foreign Exchange strategist at BNP Paribas saw that the
market was jittery after the announcement but that the package was above consensus
leading to broad-based but minor pressure on the dollar. According to Mr. Galy, "the
yield curve steepened because of the duration treasury that the Fed is purchasing."
According to Jay Feldman Director of US Economics at Credit Suisse, the Fed
more or less met market expectation and left the 600 billion dollar easing program open
ended if by the Q2 2011 the Fed has not met its goals on inflation and GDP. He has
expectation for Federal Reserve to "do more in the future” and “for the program to be
quite large."
In contrast, Drew Matus Senior US Economist at UBS Securities saw that the run-
rate of the program was lower than market expectations but that the scale was larger. The
longer than consensus time frame signals to him that "the Fed is concerned about its
inflation expectations" and that because of an unclear overall outlook its language about
revision to the program “shouldn't be taken lightly." If recovery comes quicker than
expected, language gives the Fed the ability to alter its commitment.
In easing, the Fed seeks to lower interest rate returns on savings assets, creating
incentives for investment by business and households. It believes lowering costs of
capital to finance purchases and raising the opportunity-costs of current spending will
increase economic output. Additionally, lower long-term interest rates makes risky assets
more attractive for those seeking investment return, while purchases increase the supply
of dollars and lower its value.
Since Fed President Ben Bernanke and NY Fed President William Dudley
signaled the need for a second round of easing in speeches this October, the market
forecast an open-ended commitment to purchase 500 billion dollars of Treasuries over six
months with the Fed revisiting purchase decisions at each meeting. Since investors began
anticipating easing the S&P 500 has rally 14 percent, the dollar index has dropped 7
percent and yields on the 2-year and 10-year Treasury bond have fallen to .34 and 2.625
percent.