by Elliott Morss, Morss Global Finance
Introduction
There has been far more speculation about when the latest round of quantitative easing will end than what it will mean. Hopefully, the economy will soon show enough upward momentum so the Fed can end it shortly. In what follows, the economic effects/investment implications of its ending are spelled out.
QE has come to mean that a central bank is trying to stimulate the economy by buying a large amount of “financial paper”. Table 1 indicates that since 2007, the Fed’s efforts to first stabilize and then stimulate economic growth have resulted in its assets increasing by $2.8 trillion (440%). Bernanke has been able to do this because the Fed has unlimited power to print money. Looking at the year-to-year changes (September to September) shown in the Table are interesting. The Fed’s holdings of Treasuries actually fell between September 2007 and 2008. Those were still the “boom” times. That all changed in the next 12 months when the Fed’s assets grew by $995 billion. During that period, the Fed bought huge amounts of Treasuries, Federal agency debt (mostly housing), and mortgage-backed securities. In its effort to save AIG, the Fed also purchased its Maiden Lane partnerships.
Source: Federal Reserve
At the end of last 2013, the Fed announced it would buy $85 billion of “financial paper” every month: it would pay out a non-interest-bearing US debt (money) for interest-bearing US debt (Treasuries) and other securities. It said this would continue until either the unemployment rate fell below 6.5% or the inflation rate exceeded 2.5%. And in 2013, the Fed has purchased about the same amount of Treasuries and mortgage-backed securities.
Economic Effects of QE
a. Theory
A significant purchase of any form of fixed income security will increase its price and lower its return. And in that regard, the Fed’s QE has been quite successful. Interest rates on Treasuries have been kept low. The economic question is now whether these lower rates are increasing consumer and business expenditures resulting in job creation. This is not clear: Keynesians talk of “liquidity traps” where downward adjustments of interest rates have no effect on expenditures and hence no new jobs. One unintended consequence of the Fed’s QE program is that people living on fixed incomes are having trouble getting by because Treasury rates are so low.
There is another dimension of the Fed’s QE program that is often missed: its effects on international capital flows. When US rates fall, capital flows out of the US. This puts downward pressure on the dollar making US goods more competitive on international markets. Many countries do not like this because it makes their goods more expensive and they try to neutralize it by buying US dollars. By the same token, when QE ends and US rates increase, capital flows back into the US and the dollar strengthens.
b. Empirical
i. Interest Rates
Table 2 shows what has happened to US interest rates in the last six months. Both mortgage and long term Treasury rates have increased significantly while credit card rates have not changed.
Sources: creditcards.com, bankrate.com, and the US Treasury.
Since there has been no change in the Fed’s QE program, the jump in rates is probably attributable to the effects of the economy gaining momentum.
ii. The Economy
According to the National Association of Realtors, home sales continue to grow despite higher mortgage rates. The Institute for Supply Management‘s indices for both manufacturing and non-manufacturing remain positive. Employment is growing but slowly. And even with the stronger dollar resulting from QE, US exports continue to grow. Is QE having much of an effect on the economy? Hard to say. But the recovery is not all that robust. And remember the ’29 depression was not really over until the demand generated by World War II. In these circumstances, it is understandable that at least for now, the Fed has decided to maintain QE.
iii. Currencies
Theory suggests that QE, by keeping interest rates down, is causing the US dollar to be weaker than it would otherwise be. Empirically, this is hard to see because of other factors affecting exchange rates.
Investment Implications
One way to foresee what the effect of ending QE will be is to look at the effect of Chairman Bernanke’s statement made on June 19th suggesting that QE might be reduced later this year:
“If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.”
Table 3 shows what effect Bernanke’s comments had by looking at prices a month earlier and just after the speech.
Source: Yahoo Finance
The data suggest Bernanke’s comments had a greater impact on the overall market – the S&P 500 (^GSPC) – then on bonds overall as measured by the Vanguard Total Bond Market (BND) ETF. However, as suggested in the Theory section above, the impact of the announcement was far greater for foreign debt. The suggestion that US rates would increase soon and thereby draw fixed income investments back into the US caused the JPMorgan (EMB) and Wisdom Tree (ELD) ETFs to fall by more than 10%. The same happened to the TCW (TGEIX) mutual fund. The announcement also caused real estate investments to weaken as measured by the iShares (IYR) ETF and the Fidelity (FRIFX) mutual fund.
Conclusions
The markets took Bernanke’s June speech as an indication that QE would be reduced in the near future, and as such, it provided a good indication of what might happen when QE is actually reduced. However, it should be kept in mind that Bernanke has also said QE will not be reduced until it is clear the economy, including real estate, is on a sustainable growth path. So I view the sell-off in real estate investments as an opportunity to buy in at a good price. However, foreign debt investments are likely to be hurt when US interest rates increase, so their sell-off will likely be continued when QE is actually reduced.
