This fall, the Federal Reserve announced its widely anticipated third round of quantitative easing, commonly referred to as “QE3.” The aim of this latest initiative is to keep interest rates low in order to encourage investor risk taking and investment in the economy. Like the two rounds of easing that preceded QE3, the Fed will purchase bonds, targeting in this iteration the agency mortgage-backed securities market. The Fed intends to purchase approximately $40 billion in assets per month, and while the length of the bond-buying program is uncertain, it will likely continue until the labor market shows substantial improvement.

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The effect that QE3 will ultimately have on the economy and the markets depends on, first, the velocity of money, or how quickly credit is able to move through the financial system; and, second, the psychological signal that the Fed is sending. Investors have come to expect that the Fed will do everything within its power to pursue its dual mandate of stable prices and maximum employment, and launching QE3 has thus far been interpreted as an encouraging sign.

However, with the announcement of QE3 and Europe kicking off its own open-ended bond-buying program, there is reason to believe that both economic growth and inflation could tick up, which would likely result in higher long-term rates. We feel the greatest potential cause of a significant rise in long-term interest rates would be if investors came to believe that the flow of federal stimulus were being wound down too quickly for other market participants to pick up the slack in the demand for Treasuries and agency mortgages.

Read more in the latest issue of Putnam’s Fixed Income Outlook.

Putnam Perspectives: Fixed-Income Outlook Q4 2012