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									MGM Mirage
Special Comment
Credit Research | United States
Economics Research and Strategy | Americas

QE Thoughts: 2’s Company, 3’s a Crowd                                                     1 3 J UNE 2 0 1 1

Because of the Fed’s price stability mandate, a second round of large-scale asset
                                                                                          Contributing Analysts
purchases, or so-called “QE2”, was an appropriate policy response last year as
deflation risks were rising. QE2 not only helped reverse the trend in disinflation, but
it also acted as a catalyst for higher stock valuations and a weaker dollar.              George Goncalves
                                                                                          Head of US Rates Strategy
However, QE2 proved to be no panacea. Home prices continued to decline and the            +1 212 667 2254
labor market recovery remains lackluster. That said, we think QE2 helped to raise
investor confidence by buoying risk markets via the portfolio rebalancing effect,
                                                                                          David Resler
while arresting and then finally reversing deflation concerns in the marketplace.         Chief US Economist
As the midpoint of calendar year 2011 nears, there have been weaker data prints           +1 212 667 2415
and a pullback in risk markets. This has led to speculation about “QE3”.
QE3 remains a tail event in our view; however, the impact of such a policy would          Jens Nordvig
be negative for the dollar as it could disrupt stable inflation expectations via an       Head of G10 FX Strategy
offsetting rise in commodity prices. It can also be argued that another round of QE       +1 212 667 1405
could crowd out bond investors and further damage daily liquidity.
In this report we compare the conditions that led to QE2 versus how those
variables are performing in 2011. In our opinion, at this juncture, no further
quantitative easing is needed – with our reasoning provided as follows:
                                                                                          Aichi Amemiya
    •   Deflation risks have abated making it difficult for the Fed to justify another    US Economist
        round of long-term asset purchases. Even with the recent declines in              +1 212 667 9347
        commodity prices and TIPS inflation expectations, deflation probabilities
        implied by the market remain floored around zero.                                 Jeffrey Greenberg
                                                                                          US Economist
    •   Because of recent Fed speak, a push for easing beyond QE2 would likely            +1 212 667 2335
        face strong dissent from within the FOMC, adding to the criticism from both
        Congress and overseas, especially emerging markets.
    •   In our view, it is prudent to expect the Fed to stay on hold for longer. Just     Stanley Sun
                                                                                          US TIPS & Rates RV Strategist
        two months ago, markets expected multiple rate hikes in 2012; now, they
                                                                                          +1 212 667 1236
        hardly expect one. We continue to forecast the first hike in Q1 2013.
    •   The bond markets, especially the front-end and short-intermediates on the
        curve are adjusting to this new reality of a Fed on hold. There has been          Anish Abuwala
        bull flattening from the 3-year point out to 7s as rolldown and carry trades      FX Strategist
        remain in favor.                                                                  +1 212 667 9934
    •   If the 5y5y inflation starts to trend lower, the market may start to price in
        QE3 and hence bring the 5y5y back in the range. Such self-correcting
        mechanisms could make QE3 even more unlikely.
                                                                                          Table of Contents            Page
    •   Given that private consumption has been boosted by higher equity prices
        we believe that wealth effect of equity price fluctuation matters now more        Economics Overview           2-4
        than ever for the Fed. Granted stocks investors are becoming more                 Rates Implications           4-7
        defensive (potential for small to large cap, growth to value rotation –
        see link) we imagine that the Fed will need to see a drop of more than 10%        Dollar Implications          7
        before getting concerned about recent risk market behavior.

                                                                                               Nomura Securities International Inc.

See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures
Nomura | Special Comment                                                                                                  13 June 2011

Don’t count on QE3 materializing
A spate of weak data has led to expectations of easing: Most recently May’s
employment report showed 54k jobs were added to nonfarm payrolls, reinforcing
sentiment that the US economy is sliding through a soft patch and increasing
speculation of QE3. Market expectations have swung from expecting multiple rate
hikes in 2012 to no more than one rise next year (Figure 1).
A high bar: We regard the recent wave of disappointing economic data to be
transitory (see “US Roundup: Blame Mother Nature” 27 May 2011). Consequently,
we judge it highly unlikely that the Federal Open Market Committee (FOMC) would
authorize a further expansion of its balance sheet via large-scale asset purchases
(LSAPs). Indeed, Fed officials, in recent weeks, have sought to deflate
expectations that a third round of quantitative easing (QE) might be under active
consideration. Expressing a view that seems to be shared by other policymakers,
Federal Reserve Bank of Atlanta President Dennis Lockhart recently asserted that
“there is a very high bar to another round” of QE. However, because the FOMC’s
policy reaction function (how it might react to various developments) is neither
clearly spelled out nor well-understood, speculation of the prospects for further QE
persists. But one thing seems clear: the circumstances that led the Fed to
announce QE2 in November do not exist today.

Figure 1. Tracking implied Fed funds rate                          Figure 2. Higher inflation and inflation expectations
expectations at the two-day FOMC meetings in 2012                  set high bar for further quantitative easing

                                                                      %          QE1           QE1        QE2
 %, 5-day moving avg.
 1.4                                                                 3.0
                                                                                 End           Lite

 1.0                                            October
                                                2012                 2.0
 0.8                                2012

 0.4                                2012                             1.0
 0.2                                Jan                     0.15
                                    2012                    0.13     0.5
                                                            0.09                                                         Core PCE
 0.0                                                                                                                     inflation
    Jan-11     Feb-11      Mar-11      Apr-11      May-11            0.0
                                                                       Jan-10   Apr-10    Jul-10      Oct-10    Jan-11      Apr-11

Source: Nomura FOMC Implied Probability Report (see link)          Source: Nomura Global Economics

Further easing could bring dissenters back to the table: Neither the internal
dynamics of the FOMC nor the key drivers of the economy (employment, prices,
the stock market) support further easing. Even if the core dovish members of the
FOMC—namely, Chairman Bernanke, Vice Chair Janet Yellen, and NY Fed
President Bill Dudley—supported more asset purchases, they would likely face
vigorous internal opposition from a bloc of voting members. Both Philadelphia Fed
President Charles Plosser and Dallas Fed President Richard Fisher have made
clear that they oppose QE on theoretical grounds while Minneapolis Fed President
Naryana Kocherlakota, has advocated that the FOMC begin its exit strategy before
the end of 2011. Thus, we suspect that, barring a more convincing decline in
economic activity, a majority FOMC vote in favor of further QE would be
accompanied by three (or more) dissenting votes. No FOMC meeting has
produced that many dissents since November 1992 when two members favored a
tighter policy stance and one an easier stance than the majority. We suspect that
no FOMC member would be willing to take the risks of an adverse reaction to a 3-

Nomura | Special Comment                                                                 13 June 2011

vote dissent opposing further QE. We believe that QE2 has achieved its primary
objectives of averting near-term deflation and stabilizing long-term inflation
expectations, so we see little if any support on the FOMC for further QE at this time.
“Stock view” means QE2 does not “end” in June: Another important factor
arguing against further easing is how the Committee believes QE works—through
the size of the balance sheet (“stock view”) rather than the purchase of securities
(“flow view”). Chairman Bernanke emphasized this point in his first-ever press
conference following the 27 April meeting:
         …we subscribe generally to what we call here the ‘stock view’ of
         the effects of securities purchases…by which I mean that what
         matters primarily for interest rates, stock prices, and so on is not
         the pace of ongoing purchases, but rather the size of the portfolio
         that the Federal Reserve holds. And so, when we complete the
         program…we are going to continue to reinvest maturing
         securities…and so the amount of securities that we hold will
         remain approximately constant….the amount of ease, monetary
         policy easing, should essentially remain constant going
         forward…from June.
Thus, according to the “stock view,” the end-June cessation of further purchases
will not end the easing provided through an enlarged Fed balance sheet. That
easing of policy will persist after the purchase program ends (We have made clear
that we concur with this interpretation of the channels of QE see “Global Letter:
QE2 working but Fed communications may not be,” 17 December 2010). By
contrast, after market operations under the first round of quantitative easing were
completed in March 2010, the Fed let their MBS portfolio run off until last August.
Allowing its balance sheet to contract then amounted to a passive tightening, so, it
was appropriate to call that “the end of QE1.”
Deflation risk spawned QE2: When the FOMC launched QE2 last November,
deflation seemed to be a clear and present danger. The trajectory of inflation
based on the Fed’s preferred measure of “underlying inflation,” the core personal
consumption expenditure (PCE) deflator, had been trending lower since March
2010. On a year-over-year basis, this metric dropped to 0.73% in December 2010
compared to 1.78% in March 2010, reaching a rate far below the Fed’s widely
believed target of around 2.0%. Disinflation was prevalent and deflation posed a
serious risk. Moreover, the decline in the high frequency indicator of long-term
inflation expectations – the 5-year breakeven inflation rate -- over the May-
September period magnified worries that the economy might be on the brink of
In Chairman Bernanke’s August 2010 Jackson Hole speech in Wyoming, he hinted
that deflation risks were looming and highlighted that, “if deflation risks were to
increase, the benefit-cost tradeoffs of some of our policy tools could become
significantly more favorable.” However, at the April press briefing, the Chairman
outlined why the bar is much higher for further QE:
         The tradeoffs—are getting less attractive at this point. Inflation has
         gotten higher. Inflation expectations are a bit higher. It’s not clear
         that we can get substantial improvements in payrolls without some
         additional inflation risk. And, in my view, if we’re going to have
         success in creating a long-run sustainable recovery with lots of job
         growth, we’ve got to keep inflation under control. So we’ve got to
         look at both of those—both parts of the mandate as we—as we
         choose policy.
The tables have turned: concern has shifted from concerns about deflation in 2010
to anxiety about excess inflation in 2011. Further QE would not be implemented
with inflation risk looming.
Unemployment concerns have not led to asset purchases: Under the Fed’s
dual mandate, a chronically weak job market (reflected in the persistently elevated

Nomura | Special Comment                                                                                                                     13 June 2011

unemployment rate) might also seem to be sufficient cause for further quantitative
easing. To be sure, growth in nonfarm private payrolls slowed significantly in late
May-August 2010 to an average 79k compared to an average 187k per month over
the March-April period, yet the month-over-month increase in private employment
accelerated gradually thereafter from May to October. In addition, the
unemployment rate remained essentially unchanged over the same period.
Compared to striking changes in inflation-related indicators, there had been no
convincing shift in the gradual recovery in the labor market during the period when
the debate over implementing QE2 intensified within the Fed (Figure 3). Against
this backdrop, although the weaker-than-expected employment report for May
2011 raised expectations for QE3, a soft reading in a single month is not enough to
motivate the Fed to take additional easing steps.
What would it take? Taking into account the strong link between consumer
activity and financial asset prices, a precipitous drop in stock prices would likely
exert a significant drag on the real economy and could also signal financial
instability. Therefore, a big decline in stock prices could signal a need for additional
easing. Even though Fed officials are quick to remind markets that they do not
target asset prices, QE2 fostered conditions that generated a helpful lift to share
prices. Speaking before the National Press Club in February, Fed Chairman Ben
Bernanke stated that, “the Federal Reserve’s securities purchases have been
effective at easing financial conditions. For example, since August, when we
announced our policy of reinvesting maturing securities and signaled we were
considering more purchases, equity prices have risen significantly.” Figure 4 shows
that variations in stock prices have generally preceded the Fed’s QE policy actions
by a few months (see “US Special Topic: An equity price slump as potential trigger
for QE3,” 10 June 2011). Casual observation suggests that a decline of 10% or
more in equity prices could be a harbinger of further QE. At this time, we do not
envisage the Fed judging it necessary to implement another round of longer-term
securities purchases, but at the same time, we cannot rule out the possibility a
steep drop in equity prices might signal renewed financial stress.

Figure 3. Labor market concerns have not led the                               Figure 4. Stock prices appear to lead the Fed’s
Fed to further quantitative easing                                             quantitative easing programs

                                                                                  %, 3-mo change QE1 QE1                QE1               pp, inverted
 pp, 3-mon QE1                    QE1                           m-o-m,             30            MBS UST                End       QE2
           End                    Lite   QE2                  thousand,
  2.0                                                                   300        20                                                             -2.5
  1.5                                                                              10                                                             -2.0
  1.0                                                                   150         0                                                             -1.5
  0.5                                                                              -10                                                            -1.0
  0.0                                                                   0          -20                                                            -0.5
 -0.5                                                                              -30                                                            0.0
 -1.0                                                                   -150       -40                                                            0.5
    Jan-10   Apr-10     Jul-10       Oct-10      Jan-11     Apr-11                   Jan-08 Aug-08 Mar-09 Oct-09 May-10 Dec-10 Jul-11
              NFP-private (rhs)               Unemployment rate (lhs)
                                                                                       SP 500 (3-mon lead lhs)
                                                                                       QE-incorporated Fed funds rate less Taylor rule-implied FFR (rhs)

Source: BLS; Nomura Global Economics                                           Source: Nomura Global Economics

QE2 worked – arresting deflation and pushing TIPS real rates lower: Some
market participants believe that QE did not work because nominal rates rose its
implementation. Our view all along has been that “success” in achieving the Fed’s
goals of heading off deflation and ensuring against a drop in economic activity
would likely be evident in higher rather than lower long-term interest rates. In its
initial implementation, however, QE2 might effectively reduce Treasury yields and

Nomura | Special Comment                                                                                                                                                                                                           13 June 2011

spur portfolio-substitution effects that might channel additional funds to
corporations and households. However, that same substitution effect might have
indirectly driven non-yielding assets (such as commodities) to outperform dividend
and coupon based securities. Usually, interest-generating assets carry better than
physical assets as coupon income or dividends offset the cost of carry (whether it
is storage costs, repo interest, etc). With short-term real interest effectively bound
at zero, this differential has mattered less since the onset of QE2, as spot oil prices
have been outperforming equities as real yields (proxied by TIPS – see link) have
We also believe QE2 successfully dispelled deflationary concerns, and the 5y5y,
the Fed’s favorite measure of inflation expectations, has stabilized around these
levels at about 2.8% after the recent downward shift. As Figure 5 shows, 5y5y
inflation so far in 2011 has broken away from the concerning similar path compared
with 2010. We believe this is encouraging as it will be tough for the Fed to justify
further easing unless 5y5y drops near the 2% area, which in our view is an unlikely
scenario barring a double dip or a complete collapse in commodity prices.

Figure 5. The recent decline in the Fed’s favorite                                   Figure 6. In 2010 the deflation probability, as implied
gauge, the 5y5y looks like a repeat of 2010; but we                                  by TIPS markets, was an early flag for QE2 easing,
do not think a drop under 2.5% is sustainable                                        the Fed has managed to eradicate deflation fears

                                 5Y5Y 2010           5Y5Y 2011                                                                  5y Deflation Prob %                                   10y Deflation Prob %
  %                                                                                   10%
                                                                                                     QE1 Ends                                                                QE2 Begins                                                     QE2 Ends?
  3.4                                                                                  9%
  3.2                                                                                  8%
  2.6                                   2.5%                                           4%

  2.4                                                                                  3%












        Jan   Feb   Mar   Apr   May     Jun    Jul    Aug    Sep   Oct   Nov   Dec

Source: Nomura Rates Strategy                                                        Source: Nomura Rates Strategy

Granted the current softness in global commodity prices has raised some red flags,
the TIPS market breakevens have not yet signaled a growing concern about
deflation as illustrated by the probabilities implied by the inflation derivative market
(Figure 6). The market started to price for QE2 action around the peak of the
deflationary scare in Q3 2010. In contrast, the implied deflation probabilities remain
at zero, offering no support for Fed easing. Until deflationary probabilities start to
creep higher either via a declining 5y5y or a lower valuation of risk assets, the Fed
will most likely not even start to entertain the idea of QE3. As we have written in
the Global Inflation Monitor on 21 April 2011 (see link), the 5y5y inflation may be
stuck in a range for a while longer, i.e. if the 5y5y inflation start to trend lower, the
market may jump the gun on pricing in QE3 and hence bring the 5y5y back in
range. Such a self-correcting mechanism could make QE3 even more unlikely
from an expectations standpoint.
Risk markets are not calling for QE3 just yet despite recent weakness: The
experiences of QE1 and QE2 point to higher yields during QE, because of stronger
risk asset prices (the key is that the Fed displaces Treasury investors, buying their
bonds in the hope that investors “portfolio rebalance” in other markets) and higher
inflation expectations, only to see the unraveling of both when QE ends (in our
opinion the decline in rates after QE is a sign that either the Fed did not do enough

Nomura | Special Comment                                                                                                                                                                                                                                                                                                   13 June 2011

to stimulate the economy/confidence in the markets and/or market participants
frontload and price-in the stimulus too quickly). So far in this cycle, the price action
has been fast tracked with Treasury yields and TIPS breakevens starting to fall
even before June 30 (Figure 7). Unless overseas sovereign concerns escalate and
data keep turning weaker (not our base case), we are still far away from any
market pricing of QE3 in the bond market.
In risk markets we use the curve as our anchor versus stock performance. In
Figure 8 we illustrate that the 2s10s curve has been closely correlated with equities
during QE. Figure 8 also shows that pre-QE2 (the area represented by the 1
range) there was little correlation. If stocks manage to stay in the 2 range, we
then think market participants should not expect the Fed to come to the rescue with
more liquidity (i.e., perhaps this is just a correction in valuation as the economy
transitions away from stimulus to underlying fundamentals where the economy will
catch up to P/Es or vice-versa). As mentioned above, we believe that the equity
wealth effect channel matters now more than ever for the Fed. Granted stocks
investors are becoming more defensive (potential for small to large cap, growth to
value rotation – see link), we imagine that the Fed would need to see a drop of
greater than 10% before getting concerned about recent risk market behavior.

Figure 7. Market Conditioning: the recent price                                                                                                                   Figure 8. The Treasury curve has been a driver of
action has fast-tracked the usual end of QE bond                                                                                                                  equity performance in QE2. We do not expect the
performance: lower yields and lower breakevens                                                                                                                    curve to flatten completely until the Fed raises rates

 %                           10yr Treasury Yields     10y BE's                                                                                                                                                              2s10s (LHS)                                       S&P 500 (RHS)
 4.50 MBS QE announced                       MBS QE Ends QE Lite              QE2 Ends ?                                                                            300                                                                                                                                                                      1400
      UST QE being considered    UST QE 1 ended         announced       1st FOMC Q&A                                                                                                                                                                                                  2.)
 4.00        UST QE 1
                                                                 QE2 begins                                                                                                                                                                                                                                                                  1350
 3.00                                                                                                                                                               260
                                                                                                                                                                    240        1.)                                                                                                                                                           1200
 1.00                                                                                                                                                               200
                                                                                                                                                                    180                                                                                                                                                                      1000




















Source: Nomura Rates Strategy                                                                                                                                     Source: Nomura Rates Strategy

Fed expectations and rolldown/carry trades drive yields across the curve:
Expectations of a Fed hike have dropped meaningfully since April. A combination
of lower GC funding rates and Fed expectations has made investors comfortable
again with roll-down and carry trades in the front-end and intermediates. As Figure
9 shows, on a five-year rolling basis, the average level of 10-year yields has glided
down with the overall level of Fed Funds, regardless of Fed cycles. Ultimately, the
Fed sets future expectations for interest rates, and the bond market listens. Until
there is a shift higher because of inflation concerns (which would imply that the Fed
would need to raise rates to fight that headwind) or a credit risk premium is
embedded in the bond market, we do not expect Treasury yields to decouple from
expectations of future fed rate levels. We extrapolated our Fed hike forecasts into
this time series and spread the average future 10-year based on the historical
spread between 10s and the Fed. The longer the Fed is on hold, the tighter the
spread can become between Fed funds and 10yr. Although the market may at
times sell off (e.g. the last two November and Decembers), we think these periods

Nomura | Special Comment                                                                                                                                                                                                                                                                 13 June 2011

should be viewed as buying opportunities because a squeezing of the curve,
starting with 2s through 10s, could keep 10-year yields under 3.5% on average for
quarters to come.

Figure 9. US rates have been declining on average                                                                                                                                 Figure 10. Although market speculation surrounding
for years. We still believe the Fed ultimately sets                                                                                                                               QE3 has picked up lately, the number of Google
the level of expectations for rates across the curve                                                                                                                              searches for QE3 now vs QE2 last year remains low

  %                                  5-year Average of 10y UST yields & Fed fund rates
  14                                                                                                                                                                                5.0                                                Google Searches
                                                                                                                                                                                                                                                                 qe2                 qe3
  10                                                                                                                                                                                3.5
   6                                                                                                                                                                                2.0
   4                        10yr Treasury
                            Fed Funds                                                                                                                                               1.0
   2                        10yr Treasury (assuming historical FF-GT10 sprd)                                                                                                        0.5
                            Fed Funds (with Econ Forecast)
   0                                                                                                                                                                                0.0

























Source: Nomura Rates Strategy                                                                                                                                                     Source: Nomura Rates Strategy

Dollar implications of QE: From the onset of QE2, two factors have fuelled sharp
dollar depreciation. First, was the increased usage of the dollar as a funding
currency owing to expectations for persistently low interest rates in the US. Second,
was a shift of market participants out of US Treasuries and into riskier assets.
However, with the end of the Fed’s Treasury purchases now approaching, we
believe the liquidity/funding dimension of the USD downtrend is set to fade. While
cheap dollar funding is firmly entrenched, the migration into risk assets is not. This
is already evident in US equity markets, as US growth expectations have been
revised lower and doubts have risen as to whether current valuations can be
justified on a discounted cash flow basis. Typically, the dollar performs well in such
a ‘risk-off’ environment. However, rate differentials remain wide and the prospect of
further tightening in the rest of the developed world should mean any dollar gains
will be only momentary.For these reasons, we see the dollar trading with greater
two-way risk over the next two to three months. While QE3 remains a tail event in
our view, the impact of such a policy would be negative for the dollar, based on the
past (for more information please see - QE and the Dollar: Lessons from QE-1
(Part I) and QE and the Dollar: International Lessons (Part II)].
We see a long period of the Fed on hold and carry & rolldown remaining the
theme: We think FOMC members will continue to await a return to business as
usual—a “plain vanilla” portfolio consisting only of US Treasuries, and a monetary
policy implemented only through adjustments in the target rate—for the
foreseeable future. While we do not think further QE will emerge from more weak
data, continued disappointing data will likely lengthen the Fed’s inactive, wait-and-
see monetary policy. We do not expect passive tightening of the Fed’s portfolio—
via allowing maturing MBS principal to roll off the balance sheet rather than being
reinvested—until the middle of 2012, and we do not think the first Fed funds rate
hike will occur until early 2013. Along the way, we look for the FOMC’s
communication strategy as likely to be the first line of action in steering the
economy toward the Fed’s mandates, coming well before a shift in actual policy.
Given the high hurdle for QE3, we need to see the risk market underperform further
and/or deflation probabilities rise higher for the Fed to start entertaining the idea of
QE3. Until then, we expect yields to remain lower for longer as carry and rolldown
remain the theme.

Nomura | Special Comment                                                                                                                        13 June 2011

                                                               Disclosure Appendix A1
We, George Goncalves, David Resler, Jens Nordvig, Aichi Amemiya, Jeffrey Greenberg, Stanley Sun and Anish Abuwala hereby certify (1) that the
views expressed in this report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this report, (2)
no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report and (3)
no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura
International plc or any other Nomura Group company.
Additional Disclosures required in the U.S
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Nomura | Special Comment                                                                                                                     13 June 2011

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