As expected, the Federal Reserve announced Quantitative Easing II (QE II). There were no surprises here, the reports over the past weeks were indicating easing in the amount of a few hundred billion to up to $1 Trillion. The headline number is $600B, but the total will be closer to $1 Trillion if you include additional purchases to replace expiring mortgage bonds. The additional purchases don’t expand the Feds portfolio, they will simply replace existing positions.
This sounds like a lot of money, but put $600B in perspective. It’s less than 6 months worth of the U.S Federal Government’s budget deficit. The entire U.S economy is over $14Trillion dollars.
One of the important details about QEII is that the majority of the Fed purchases will be within the bond maturity window of 5-7 years. This is important because the Fed will eventually need to reverse QEII as well as unravel all its other existing positions.
How It’s Supposed to Work
The Fed is trying to accomplish a few things here with QEII. First, the purchases will cause interest rates to decrease because buying bonds increases prices. Bond yields go in reverse to bond prices, so these purchases tend to depress bond yields. Lower interest rates in theory makes credit more easily available (this argument doesn’t reflect reality though – just ask people who are trying to get those cheap mortgages).
Second, lower bond yields make government debt less attractive. This will make other productive, private market assets more attractive because the risk adjusted return rate of those assets should go up. This phenomenon is thought to be contributing to the rise in the stock markets, particularly income investments. Why earn 2+% on a 10 year Treasury when much higher yields are available from the highest quality, AAA rated, stocks?
Will it work? Perhaps it might have some effect marginally though its clear that in the short term the markets think it will simply cause inflation as evidenced by the increase in prices of hard assets such as gold and commodities. In the end though, the Fed can’t make a recovery happen by printing money, that needs to happen from the private sector.
How The Fed Will End It
I think the more important question to ask is how will the Fed end it. If you have been making the right moves recently, you will want to keep an eye out for new bubbles developing that could blow up on you because of the Fed’s actions. All this Fed manipulation is after all artificial market fingering. Markets are smart, and they adapt. The best example of this is that these artificially low interest rates really haven’t done that much to make credit more available because lenders have rightly raised standards.
Buying Treasury Bonds gives the Fed a clear and easy exit strategy: hold the bonds to maturity then retire the money. The Fed’s action to focus on the 5-7 year time frame leads one to conclude that this might be their exit time frame.
Inflation could occur more than otherwise if the Fed was forced to sell the assets at lower prices or worse simply write the money off. Because bond prices are so high, any sign of a growing economy will only make these bonds lose value. So, the risk of extra inflation will depend upon if the Fed takes a bath on its assets when it starts tightening. Simply letting the bonds expire to maturity enables the Fed (or anyone else invested in Treasury bonds for that matter) to get all of their principal back. This is the best that can be hoped for to keep inflation in check.
Gold Is A Bubble
The biggest risk I see going forward is a gold bubble. Not next year, maybe not even in the next few years but at some point gold won’t be a good trade anymore (at least a long trade). Here’s why:
- Gold doesn’t make you money. If you buy quality stocks and overpay because of bubble pricing, at least you won’t lose your shirt because stocks can outgrow overvaluation if earnings increase. Gold can’t do this.
- Inflation won’t be the problem it was in the 1970s when gold was a bubble last. Don’t expect 18% interest rates, the Fed will move.
- Gold has technicals in the market that make it a good trade. When the trade goes against it those market speculators will be weeded out.
Gold will probably never be $300 again because world demand for jewelry and industrial uses will continue to increase as markets develop around the world. But, at some point this trade won’t work anymore.