QE2 – October 2010

October 25, 2010

Dow Jones Average: 11,133
S & P 500 Index: 1,183



For the past few months the investment community has been focused on the upcoming launch of QE2, which is not a reference to the ocean liner. The acronym QE2 stands for a second round of quantitative easing; an aggressive, controversial, financial tactic that the Federal Reserve Bank has chosen to use during this period of economic stress. Even though the Fed already deployed 1.7 trillion dollars on the first round of quantitative easing, they now feel that a second dose is necessary. In layman’s terms “quantitative easing” is simply the government printing money and pushing it into the economic system.

The Federal Reserve Bank of the U.S. has the authority to create money at will, money it can use to buy and hold assets (typically bonds) for its own account. During 2009-2010 the Fed bought 1.7 trillion dollars worth of debt instruments (mostly mortgages) from banks that wanted to unload somewhat illiquid paper. The interest rate on mortgages declined in 2009-2010, largely because the Fed dominated the mortgage market and dictated the rates.

In normal times the Federal Reserve Board sets short-term interest rates and lets the free market action of buyers and sellers determine longer-term rates. The Fed set short-term interest rates at zero almost two years ago. With rates at zero the Fed could do nothing more to stimulate the economy through further short-term rate reductions. So the central bank turned its sights on the mortgage market, driving down rates in the hope that low mortgage rates would revive the housing market. The housing market has remained in the doldrums, leading some to claim that QE1 was a failure. There is almost no historical evidence that central bank actions can restore an economy severely damaged by a credit bubble and subsequent collapse. Despite record low interest rates, most people are still reluctant to invest in real estate, the asset class that hurt so many people so recently.

While history suggests that Federal Reserve Board policy has a limited impact on a post bubble economy, the Fed is nonetheless determined to re-load its monetary cannon. The financial markets expect and are counting on the Fed to create another trillion dollars or so, which will finance Fed purchases of U.S. Treasury bonds. The yield on ten-year treasury notes has fallen from 4 percent last spring to 2.5 percent in recent weeks, as mutual funds and other investors have been buying in anticipation of market moving purchases by the Fed. By signaling that another round of quantitative easing is at hand, the Fed now has to act as expected or risk a sharp downturn in the bond and stock markets.

A discussion of Federal Reserve Board machinations is always a bit dry, but important, as the implications for all markets and asset classes are significant. As the Fed cranks up the money printing machine the value of the U.S. Dollar goes down, while the prices of internationally traded commodities such as oil, gold, copper, etc., go higher in U.S. Dollar terms. The increase in liquidity (supply of money) is pushing interest rates down to record lows and squeezing investors into poor choices. Some are loading up on treasury notes at yields of 2.5 percent or less, while others are buying junk bonds at the overvalued levels last seen before the crash of 2008. The U.S. stock market is chugging higher, as domestic investors struggle for yield, and foreign buyers use strong currencies to buy comparatively cheap U.S. assets. The stock market, bond market, and commodity pits have all become hyper connected to changes in the value of the U.S. Dollar, which in turn is connected to the Fed’s willingness to print more money.

The fundamental problem for the U.S. economy is 52 trillion dollars of debt held by individuals, corporations, and government at the state and national level. Actions taken by the Fed can do little to change that reality. In the short term it seems that quantitative easing is acting as a salve on an injured economy. Bonds have never been higher in value, stocks are climbing again, and the commodity index is at a record high. It appears that things are much better, but the underlying condition that caused the credit bubble collapse has not changed much. Even though individuals are starting to save more and pay down some debt, it will take a decade to make a serious dent in the 52 trillion-dollar, debt overhang.

In our opinion, the Federal Reserve Board has become overly involved in planning and doctoring the economy. Since the late 1980’s (the Greenspan era) every attempt by the Fed to bolster the financial markets or stimulate the economy produced a bubble in some asset class, i.e., stocks, real estate, and commodities. It seems quite likely that the Fed’s quantitative easing strategy is producing a new bubble in the bond market.

Current Strategy

Investors in stocks have experienced a roller coaster ride this year. The market was up earlier in the year, experienced the worst June in about 60 years, fell to an eight percent loss on the year during August, and then rallied back into positive territory during September. It was the best September for stocks in 70 years. One could say that there is some indecision among investors. There are legitimate concerns about debt levels in the U.S. and Europe, and fears about overbuilding in China. After a decade of negative returns and the implosion of 2008, most investors would probably shun the stock market altogether if bond yields were somewhat higher. With interest rates at essentially zero on short term paper, there is tremendous pressure to be invested in stocks for dividends and possible appreciation. Stocks will remain volatile as long as investors are simultaneously desperate for returns and afraid of losing their shirts again.

We made a significant number of stock purchases when share prices fell sharply late June and early July. We felt that the decline in share prices was overdone given the steady improvement in corporate profits over the past year. In spite of high unemployment, corporations are producing profits that in some cases are not reflected in the stock price of the company. Our enthusiasm for stocks that appear somewhat undervalued is tempered by concerns about the macroeconomic picture in the developed economies and in China. The economy and the markets have become addicted to government stimulus programs and easy money from the Fed. As those programs wind down or become stymied by political battles, the economy may return to a more depressed state. The sharp rally in September has left stock prices at a vulnerable level, if the economy shows signs of renewed weakness.


The bond market is entirely frustrating to us and to most investors looking to make new fixed income investments. Yields have tumbled to miniscule levels on the lower-risk, fixed income categories (treasury inflation protected securities, and highly-rated municipal bonds) that we have favored over the past twelve years. In a barren world for fixed income investments, even higher-risk, longer-term bonds are priced to offer historically low yields. We do not think that bond market investors are being adequately compensated for the risk of default or future inflation. Although not a direct bond equivalent, dividend paying stocks are an alternative that we are now using for income generation.

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