Which Will Come First: The Fed Hikes Rates or QE4?

The investment banking world seems to be quite concerned about the so-called “end of QE3.”

End of QE3 a Top Concern and Well-Grounded in Experience

Indeed, in discussions about global economic conditions, current top concerns seem to put the end of QE3 just as high in importance as slower, but still robust, growth out of China or a potential recession in Europe (some analysts perhaps even have the end of QE3 as higher than China or Europe concerns).

The investment bankers’ concerns about what the end of QE3 might mean for the market are well grounded in recent equity market performance. The figure below depicts the performance of the S&P 500 and the expansion of the Federal Reserve core balance sheet. Three points are important. The end of QE1. The end of QE2. And the end of QE3. If one follows these points upwards to the performance of the S&P 500 (top graph), it clearly shows a connection.

1 QE jsd.fw

History of Quantitative Easing

Now some background. QE1 ended in June 2010. In anticipation of the end of QE1, the market responded, with the S&P 500 declining around 15% from peak to trough (April to mid-August).

The response of the market and concerns about the strength of the economy led the Fed to announce $30 billion in Treasury securities, keeping the Fed’s balance sheet at $2.05 trillion (absent this move, the Fed’s balance sheet would have naturally declined as bonds are paid off).

In Bernanke and Fed officials’ views, the economy was still on shaky ground. Only five months after officially ending QE1, the Fed announced QE2, a $600 billion bond-buying program. QE2 didn’t last too long, ending in July 2011. Akin to the end of QE1, the market was displeased with the Fed’s actions, with the S&P 500 dropping about 15% from peak to trough.

About a year after the end of QE2, the Fed was concerned of continued slack in economic activity. The Fed’s response, unsurprisingly, was QE3. On September 13, 2012, on an 11-1 vote, the Fed announced QE3, initially set at $40 billion per month. The $40 billion per month wasn’t high enough in the Fed’s view, pushing the bond-buying program to $85 billion per month soon after the start of QE3.

About 9 months after the announcement of QE3, the Fed began tapering policy, initially dropping the bond purchase program from $85 billion to $65 billion.

Market Starts to Think About the End of QE3

With the Fed now close to ending QE3, it’s completely unsurprising to see the market start to react. Since September 18th, the S&P 500 is down about 4% as of writing. This decline leads one to wonder: which will come first – a Federal funds rate hike or QE4? With the history of quantitative easing as background, would you guess a rate hike or QE4 would come first?

Presuming QE3 ends in November/December, and the Fed’s current path of increasing the federal funds rate in June 2015, the Fed has to make it 7 to 8 months of no quantitative easing before it raises rates. Will the Fed make it to June 2015 without further balance sheet expansion?

If the previous four years is the guide, the answer is no. The market doesn’t want QE to end and the Fed is generally a market pleasing institution. Will it oblige to market opinion? Probably yes.

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