Over the next eight months the Federal Reserve will conduct QE2 – quantitative easing, the sequel. It will buy $600 billion worth of US long-term bonds in the open market, close to 7% of all Treasuries in public hands. $600 billion is also roughly equivalent to the total amount of net debt the federal government will issue during the Fed’s QE2 campaign.
The Fed has already taken short-term rates down to zero, pushing income-seeking investors and savers to chase after higher-yielding, higher-credit-risk and/or higher-duration (riskier) bonds. Now, with the magic of QE2, the Fed wants to drive long-term rates down to unseen levels and push investors of any Treasuries (short or long) towards higher-risk assets – junk bonds, real estate, stocks, and commodities.
The Fed also hopes (that is all it can do at this point) that low interest rates will nudge businesses to invest and to hire. That’s unlikely. The value of any asset is the present value of its future cash flow. As my favorite philosopher, Yogi Berra, (allegedly) said, “In theory, there is no difference between theory and practice. In practice there is.”
In theory, lower interest rates decrease the rate that businesses use to discount future cash flows – making future cash flows more valuable today – and that is what the Fed is betting on. In practice, however, the fickle source of lowered interest rates is not lost on businesses.
Rising government debt levels and overheating printing presses don’t generate confidence about future cash flows. High government debt eventually leads to higher taxation, higher interest rates, and lower growth. So the Fed’s action may produce an opposite result from what it intends.
QE2 is like a drug prescription that comes with the list of side effects that are often worse than the disease it was supposed to cure. It is difficult to know all the side effects and unintended consequences of QE2, but it may result in a substantial decline in the dollar, stagflation (inflation will show up not where the Fed wants it – i.e., in house prices – but where the Fed does not want it: in prices for things like food, gasoline, clothing, electricity etc.), lower economic growth and much higher interest rates. Yes, paradoxically QE2 may actually result in higher interest rates – investors expecting higher inflation will demand higher interest.
Despite the Fed’s efforts, the dollar may or may not decline against the euro. As in a race to the bottom, the US is racing with PIIGS rampaging through Europe. The Fed’s artificial manipulation of short- term and long-term interest rates creates a long-term problem for the economy. Government intervention (be it Chinese or US) in the free market creates excesses that are not allowed to self-correct and thus, leads to bubbles.
QE2’s possible success worries me more than its failure, because it will come with all the side effects I just mentioned, plus the eventual popping of newly created stock market and real estate bubbles. The Fed wants to create asset bubbles, praying for the wealth effect – stock and real estate appreciation to make people feel wealthier (at least on paper, for a while) so they will spend their phantom wealth. However, the Fed is like a Judas goat leading gullible (yield-deprived) savers to the slaughterhouse. The paper wealth that is created will vanish as bubbles burst (they always do), wealth will be destroyed, and consumers will find themselves further in debt.
Japan was QEing from 2001 to 2006 and created a bubble in Japanese bonds that partially burst, but the economy did not lift out of stagnation. Eventually, Japan stopped hiding its true intentions of propping up the equity market – on November 4th of this year the Bank of Japan announced it will be buying Japanese stock ETFs and REITs.
The Fed’s actions over the last two decades remind us of Scarlett’s famous line from Gone with the Wind: “I can’t think about that right now. If I do, I’ll go crazy. I’ll think about that tomorrow.”
Unfortunately, the Fed’s toolbox is missing a very important, must-have tool to fix the current problem: the “do nothing” tool. The “do nothing” tool would let the economy self-heal, even if unemployment stayed at 10% for a while and housing prices found (declined to) their true level.
However, that is unlikely to happen, as it requires pain. Americans have little tolerance for pain – after all, the most prescribed drug in the US is Vicodin, a painkiller. This is why, regrettably for the US, QE2 is unlikely to be the last QE: as the QE2 effect wears off (assuming it succeeds at all), then QE3, 4…10 and so on will follow.
What should investors do?
If the Fed “succeeds” and creates a short-term bubble in stocks and other asset classes, investors’ true time horizons and investment disciplines (i.e. adherence to the investment process) will be put to the test. They will have to engage in the game of looking-for-a-bigger- fool-to-buy-your-overvalued-assets.
In the giddy phase of a bubble, ignorance is wonderful bliss and knowledge and adherence to the investment process are a curse – as disciplined investors will always sell too soon and will not partake in the bigger fool game. However, when the bubble bursts, the money will flow to its rightful owners. The Fed doesn’t want you to be in cash, it wants you to reach for yield and to speculate – but don’t. In the absence of good investment opportunities, the worst thing you can do is take guidance from the Fed.
Vitaliy N. Katsenelson,
for Markets and Money
Editor’s Notes: Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of upcoming The Little Book of Sideways Markets (Wiley, December 2010).