Morgan Stanley bond team faces the unexpected: can Fed avoid QE?

[NEW YORK] A year that started with almost everyone calling for the Federal Reserve to raise interest rates is drawing to a close with one of the world's largest bond dealers saying there is increasing chatter about the need for additional stimulus.

Morgan Stanley, one of the 22 primary dealers that trade directly with the Fed, says its clients began discussing the possibility that central bankers will resume bond purchases - or cut interest rates to below zero - after a weaker-than- forecast US employment report last week. The firm recommends buying medium-term Treasuries.

Another set of bond purchases would be the fourth round of the Fed's program known as quantitative easing, dubbed QE4 by traders.

"Almost immediately after September nonfarm payrolls figures flashed on the screen, the phones started ringing," Matthew Hornbach, Morgan Stanley's head of global interest rate strategy in New York, wrote in a report Oct. 6. "What's more likely: QE4 or negative rates?" "Apart from it being too early to talk about either, both QE4 and negative rates have one thing in common," he wrote. "They both mean that liftoff will be pushed back considerably." While Fed policy makers have yet to raise the idea of reviving quantitative easing, market participants are beginning to raise the idea as a slowdown in global growth curbs the US expansion. Hideo Shimomura at Mitsubishi UFJ Kokusai Asset Management in Tokyo, who knows a thing or two about prolonged recessions and deflation, doesn't think it's far-fetched.

"If the economy struggles next year, they might do more quantitative or qualitative easing," said Mr Shimomura, chief fund investor for Mitsubishi UFJ's $100 billion in assets. "There's also a chance they may cut rates. It's a story for next year." Investors haven't been dissuaded from buying Treasuries by the possibility of rising rates. US government securities have returned almost 2 per cent this year as commodities and stocks tumbled, according to data compiled by Bloomberg.

"It's definitely a reflection that sentiment has gotten pretty dark," said George Goncalves, head of interest-rate strategy at Nomura Holdings Inc., a primary dealer whose clients have also broached the QE topic. "We went from people trying to guess how many hikes we'd have in 2015, to will we hike in 2015, to will we ever hike, to will we do QE." Quantitative and qualitative easing is the term the Bank of Japan uses for its own bond-purchase programme, which extends buying beyond government debt. The BOJ is snapping up sovereign bonds, exchange-traded funds, real-estate investment trusts, commercial paper and corporate bonds as it battles more than a decade of deflation.

The Fed began buying mortgage-backed securities in 2008 and extended the purchases to Treasuries in 2009 to support the economy by pushing down borrowing costs. The purchases increased its balance sheet to as much as US$4.52 trillion in January from less than US$2 trillion. After ending the program last year, it may revive it again and include corporate bonds this time, Mitsubishi UFJ's Shimomura said.

The benchmark Treasury 10-year note yield was little changed at 2.06 per cent as of 10:24 am in Tokyo, according to Bloomberg Bond Trader data. The price of the 2 per cent security due in August 2025 was 99 15/32.

Ray Dalio, billionaire founder of Bridgewater Associates, said in August he expects the Fed to resume quantitative easing even if it first raises benchmark rates by a fraction of a per cent.

"We don't consider a 25-50 basis point tightening to be a big tightening," he wrote in a LinkedIn post. "While we might see a tiny tightening akin to what was experienced in 1936, we doubt that we will see anything much larger before we see a major easing via QE." Traders began scaling back bets that the Fed will raise rates this year after the central bank postponed raising them at its September meeting, citing threats to the global economy, futures contracts indicate.

After last week's employment report, they're now betting it won't even happen in the early months of 2016. The US added 142,000 jobs in September, versus 200,000 projected by a Bloomberg survey of economists.

The odds of a rate increase are less 50 per cent through the start of next year, only rising to 62 per cent by the time of the policy committee's March meeting, futures contracts indicate. The probability of a move by the end of 2016 is 92 per cent. The calculations are based on the assumption that the effective fed funds rate will average 0.375 per cent after liftoff.

BLOOMBERG