By Randall W. Forsyth
The coming end of QE2 continues to dominate global markets, even though you're probably as tired of reading about it as this columnist is of writing about it.
But, just as risk markets began to rally months ahead of the actual start last November of the Federal Reserve's program to purchase an additional $600 billion of Treasury securities, these same markets may be beginning to anticipate the end of the central bank's buying.
Commodities, notably crude oil, fell Monday despite the Fed's Vice Squad coming out to reassert the official line that their effect on inflation will be "transitory." Those vice officers consisted of Janet Yellen, vice chairman of the Fed's Board of Governor, and William Dudley, the New York Fed president who acts as vice chairman of the Federal Open Market Committee, the central bank's policy-setting panel. Both continued to argue in favor of the current accommodative policy, contrary to some Fed district presidents who would cut QE2 short.
That's not going to happen, but it will wind down in a bit more than two months. And while commodities appeared to begin to anticipate that eventuality, the world's biggest bond investor seemed to be doing likewise.
The Pimco Total Return Bond Fund, the world's biggest fixed-income mutual fund, managed by Barron's Roundtable member Bill Gross, was reported to be net short of Treasury securities. That wasn't a hedge of America's credit risk, as was inferred in some quarters, but the risk of rising bond yields and falling prices. Gross has written of his concern about the upward pressure on Treasury yields when the Fed departs as the buyer of first resort once QE2 ends.
But the real impact of the end of QE2 won't be felt most acutely in Treasuries as so-called "risk assets" -- those sectors that offer higher returns in exchange of their higher risk, such as stocks, junk bonds, emerging markets and commodities. The effect of the Fed's Treasury note purchases has been to tamp down risk as QE2 has produced its desired effect of a forced march from low-risk assets to higher-risk ones.
What happens once the Fed's buying winds down? David Goldman, former head of credit research at Bank of America, offers a prediction in his Inner Workings blog at Asia Times' ( blog.atimes.net .)
"There's no place to hide if the Fed removes QE: yields will have to rise enough to attract savings (and no-one knows quite how high that will be), and the savings rate will have to rise, which means that consumption will fall. The prices of inflation hedges including commodities will fall, all things (such as the safety of Persian Gulf supplies) being equal. Banks will get clobbered because the yield curve will flatten; consumer stocks will get clobbered; in fact, everything will get clobbered," he writes.
If risk is to rise, then buy risk, Goldman suggests. That is, buy futures contracts on the CBOE's volatility measure, better known by its ticker, the VIX, aka the equity market's so-called fear gauge. Monday, the VIX eased further, to levels that prevailed in mid-2007, prior to the beginnings of the credit crisis, and about half the level directly following Japan's disastrous earthquake and tsunami last month.
In addition to VIX options, various exchange-traded funds and notes provide alternatives to futures. Among them are Barclays iPath S&P 500 VIX Short-Term Futures ETN /zigman2/quotes/202248173/composite VXX -6.03% (VXX), Barclays Bank PLC iPath S&P 500 VIX Mid-Term Futures ETN /zigman2/quotes/207730517/composite VXZ -0.94% (VXZ), ProShares VIX Short-Term Futures ETF /zigman2/quotes/204693647/composite VIXY -5.86% (VIXY) and ProShares VIX Mid-Term Futures ETF /zigman2/quotes/205971581/composite VIXM -0.86% (VIXM.)
Uncertainty hangs heavy over the markets. The closest thing to certainty is that QE2 will end, almost certainly by mid-year. The odds of QE3 are low, if not nil. That means a likely rise in risk. For now, risk remains suppressed, which lowers options premiums and thus the cost of buying insurance in the form of put options to protect against losses. And there's always cash, unpalatable as its near-zero return may be.
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