Who Took Away the Punch Bowl?

It's getting late. Everyone has had a good night but the host wants to ensure everyone gets home without things getting out of hand for fear that the guests will remember the hangover, not the night of witty conversation and canapés.

Federal Reserve Chairman Ben Bernanke testifies before the Senate Banking, Housing and Urban Affairs Committee on his re-nomination to the position.
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Federal Reserve Chairman Ben Bernanke testifies before the Senate Banking, Housing and Urban Affairs Committee on his re-nomination to the position.

Unfortunately for the Federal Reserve and its chairman Ben Bernanke, the decision he has to take on whether to end or extend the second round of quantitative easing, or QE2, is a lot more complicated than ordering a few taxis for some friends, and those of you who have been partying on Wall Street or in the City of London will know the party rarely ends with a taxi journey home at 10 pm and a good night's sleep.

Rather than trying to find a cab for a short ride home, investors are fretting about being left out on the street in the middle of the night and searching for someone, anyone, to buy all this US debt.

“Whether bond yields rise or fall after the current QE program is completed will depend on myriad factors, particularly expectations regarding the outlook for economic growth and inflation, and expectations regarding the next move in Fed policy” said Kevin Logan, the chief US economist at HSBC in a research note.

Logan believes Bernanke and the Fed, like all good hosts, created the conditions for investors to party hard.

“The assurance that the fed funds rate would be kept in a range of 0.0-0.25 percent through the summer of 2011 encouraged investors around the world to increase their exposure to riskier assets such as equities, high-yield bonds, and commodities,” he said.

“The Fed’s hope was that higher asset prices would produce positive wealth effects on consumption and investment that, in turn, would increase the momentum of economic growth enough to foster a self-sustaining expansion,” Logan added.

The big gains in equities, commodities and risky assets showed this policy certainly got the party going, but there are rumors that someone wants to start making coffees and pour away the rest of the punch.

“While the Fed was aiming at asset prices in US markets, the QE policy also had collateral effects on financial markets around the globe. Access to low-cost credit reinforced ebullient economic conditions in many emerging countries and added to inflation pressures. Commodities are certainly one asset class that appears to have benefited from the Fed’s QE policies,” said Logan.

“It is worth considering that as the Fed’s QE program draws to an end in June, the upward pressure on commodity prices might abate, as it did when the first QE program ended in the first quarter of 2010,” he said.

So the party could be about to end. But how will all the guests feel in the morning?

“Where we go from here depends entirely on whether the US economy lives up to those revised expectations. If economic growth is strong following the end of the QE program, then inflation risks may increase, especially as commodity prices are already at elevated levels,” said Logan.

“Alternatively if — as we happen to expect — the economy’s growth remains lackluster and inflation remains tame, then Treasury yields could decline, especially if such a development reinforced the expectation that the fed funds rate would remain close to zero even longer than currently expected,” he said. “In this environment, riskier assets would become somewhat less attractive, and buyers who shunned the Treasury market over the past several months may return.”

So we could all be hung over but have the chance to try a different party tomorrow night then.