Photographer: Andrew Harrer/Bloomberg

Morgan Stanley Bond Team Faces the Question: Can Fed Avoid QE4?

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  • Below-forecast jobs growth sparks talk of quantitative easing
  • Traders have been cutting forecasts for Fed rate increases

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’s 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 U.S. employment report last week. The firm recommends buying medium-term Treasuries.

While none of the Fed policy makers have discussed reviving the program known as quantitative easing in their public statements, some investors are debating the idea as a slowdown in global growth curbs the U.S. expansion. Hideo Shimomura at Mitsubishi UFJ Kokusai Asset Management in Tokyo says a fourth round of Fed bond purchases, or QE4, is possible. Ray Dalio, the billionaire founder of Bridgewater Associates, said in August he expects the central bank to make such a move.

“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?”

The growing number of investors questioning the chances of further stimulus, just weeks after markets were split on whether the Fed would raise rates, underscores just how disappointing economic data has been since the central bank decided to stand pat last month.

“The topic of negative rates has come up more often than QE4, but investors are starting to entertain the possibility of either happening,” Hornbach wrote in an e-mail Wednesday. “It’s our view that neither QE4 nor negative rates are on the horizon; but, of course, they are possibilities.”

Purchases Possible

Mitsubishi UFJ’s Shimomura says the possibility is not far-fetched.

“If the economy struggles next year, they might do more quantitative or qualitative easing,” said Shimomura, chief fund investor for the firm’s $100 billion in assets. “There’s also a chance they may cut rates. It’s a story for next year.”

Quantitative and qualitative easing is the term the Bank of Japan uses for its own bond-purchase program, 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 policy increased its balance sheet to as much as $4.52 trillion in January from less than $2 trillion. After ending the program last year, it may revive it again and include corporate bonds this time, Shimomura said.

‘Pretty Dark’

Investors haven’t been dissuaded from buying Treasuries by the possibility of rising rates. U.S. government securities have returned almost 2 percent 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 in New York 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.”

Former Fed chairman Ben S. Bernanke said the Fed, which had ruled out negative interest rates in 2008, might use the policy tool during a future crisis after seeing that they have been moderately successful as deployed by the European Central Bank.

“We didn’t think the benefits would be that great, but we see now since in the past few years it’s been made to work in some European countries,” Bernanke said in an interview on Bloomberg Television. “I would think in a future episode that the Fed would consider it.”

‘Tiny Tightening’

Bridgewater Associates’s Dalio said in August he expects the Fed to resume quantitative easing even if it first raises benchmark rates by a fraction of a percent.

“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 still expect the Fed to raise rates, even if they’re trimming expectations for how fast. They began scaling back bets on a shift this year after the central bank postponed the move at its September meeting, citing threats to the global economy.

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

‘Vetting Process’

The odds of a rate increase are less than 50 percent through the start of next year, only rising to 61 percent for the policy committee’s March meeting, futures contracts indicate. The probability of a move by the end of 2016 is 92 percent. The calculations are based on the assumption that the effective fed funds rate will average 0.375 percent after liftoff, versus the current target range of zero to 0.25 percent.

Investors are examining the idea of QE4 as part of their hunt for the next big opportunity, Hornbach wrote in his e-mail.

“Once you think you’ve found it, you need to take time to fully vet it,” he wrote. “Investors have started the vetting process.”