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| For the past couple weeks, we've been hearing rumors about the possibility of "QE2" – the sequel to the Fed's quantitative easing program (QE1).
QE1 authorized the Fed to go into the market and use your tax dollars to buy up trillions of dollars in mortgage-backed securities (MBS). This helped put a bid under the crippled MBS market. It firmed up prices, provided liquidity, and helped bring down long-term interest rates. (Of course, it also allowed the banks to sell nearly worthless mortgages to the Fed at premium prices – but we'll save that discussion for another time.)
Supposedly, QE1 ended in June. Now it's time for QE2.
The rumor is the Fed will now use the proceeds from MBS payments to go into the market and buy U.S. Treasury bonds. The goal here is to keep a bid under T-bond prices and keep downward pressure on interest rates.
Currency speculators are salivating over this rumor. Expectations for lower interest rates usually lead to a lower currency value. So the popular trade right now is to short the dollar and buy the euro.
The popular trade will be the wrong trade.
First, this is a classic case of "buy the rumor and sell the news." The currency markets have already reacted to the rumor. Speculators have been selling the dollar and buying the euro. If and when QE2 is announced, the market will have already discounted the news. Speculators will rush to unwind their positions. They'll buy the dollar and sell the euro.
Also, the amount of money involved in QE2 will be far less than the several trillions of dollars used for QE1. Mortgage-backed securities pay interest and principal to investors every month (think of it as the other side of your mortgage payment). According to the rumor, the Fed will use that cash flow to buy Treasury bonds. That's just a small fraction of the total value of the MBS. Investors will likely be disappointed with the amount.
Finally, the dollar looks ready to rally. Take a look... | |
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WONDERING
