Big risk-on day, as the market starts hearing rumors about additional easing. It started with yesterday's FOMC Minutes, which had this little nugget in it.
"Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated, it would be appropriate to provide additional monetary policy accommodation....A few members noted that, depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run."
And is continuing today with Ben Bernanke's testimony before Congress, where he has so far said that the economic weakness appears temporary, but the Fed stands ready to act should deflationary pressures appear.
In the past, the Fed has acted when 10 year bond yields fell below 2.5%. One would think that the Fed's buying of Treasuries would depress yields, but it actually moves the market out of bonds and into riskier assets. The real demand for bonds comes from the flight to safety trade, which happened last year and is happening again as easing expires.
The above chart is a month old, but 10 year yields are currently still trading at 2.95%. If the trend continues, QE3 could be right around the corner. QE2 was announced at the annual global central banking conference at Jackson Hole last August.
Many feel that QE3 will take the form of interest rate targeting, where the Fed would put a cap on interest rates for Treasuries of a certain maturity. Bernanke himself outlined such a program in a 2002 speech about fighting deflation when he was still a Fed Governor.
"Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time — if it were credible — would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt ... Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities ... Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond- price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade."
Such a program would not have a specific duration or amount of easing, which would cause the Fed to lose control over the size of its balance sheet.