October 2010: Quantitative Easing Explained

Quantitative Easing

The Federal Reserve is making overtures about additional Quantitative Easing.  That is, they might inject even more money into the economy in the hope of lowering interest rates and thereby stimulate rapid economic growth.  A second round of quantitative easing (“QE2”) is a de facto acknowledgment that earlier actions greatly expanding the money supply and lowering short-term interest rates have not achieved the desired result of ramping up the economy.

QE1 lowered short-term interest rates and mortgage rates.  The second round (QE2) is intended to lower long-term interest rates.  To achieve these ends, the Federal Reserve will buy long-term U.S. Treasury and Government Agency bonds to drive their interest rates lower.  Because bond prices and interest rates move inversely, the bond purchases will push their prices higher and drive their interest rates lower.  The Fed hopes that making money cheaper (i.e., reducing interest rates) will encourage businesses and individuals to borrow, using the funds for spending and capital investment.
 
The folks that brought you QE1 are hoping that more of the same will somehow result in a different outcome and recharge the economy.  But, we concur with Albert Einstein’s famous words, “The definition of insanity is doing the same thing over and over and expecting different results.”

How Is This Done?

Unlike an individual or a commercial bank, the Federal Reserve can create money by simply crediting its own bank account.  QE2 will use this new money to purchase bonds. This action will increase the money supply.  It is a massive swap, taking in bonds and putting out cash.

Quantitative Easing is the modern day equivalent of printing money.  However, instead of using a printing press, it’s done using electronic entries.  This is also referred to as “monetizing the debt,” a fancy phrase for printing money electronically to pay off or repurchase debt.

The Fed uses the “new” money it creates to buy what it wants.  For example, in 2009 through March 2010, they purchased $1.25 Trillion of mortgage backed securities, driving mortgage rates to their lowest levels in decades in an attempt to stimulate the housing market.  Yet, mortgage rates fell even lower after the Fed stopped their purchases six month ago.  Still, despite QE1 and very low mortgage rates, the housing market remains in the doldrums.

Playing With Fire

No one knows how much or how little quantitative easing will rekindle the economy, or if it will even work.  At the same time, this unorthodox, untested policy is encumbered with significant risks of unintended consequences:

  1. Reckless Allocations of Capital and Asset Bubbles: If interest rates are forced even lower, the cost of capital will be even lower.  Capital will be treated accordingly.  Cheap and abundant money (the purpose of QE) encourages reckless allocations of capital and asset bubbles as money looks for places to earn a return.  When capital is squandered it can be lost, but the obligation to repay will remain. (Sound familiar?  Like the housing bubble with mortgage debts that long endure after the bubble has burst?)
  2. Debase U.S. Dollar: Driving interest rates even lower may undermine the value of the dollar in foreign exchange markets.
  3. High Inflation: If quantitative easing is pushed too far (no one knows how far that might be), it may cause high inflation.
  4. Higher Interest Rates: If we experience higher inflation as well as a falling dollar, then higher interest rates will be a certainty.  This is the exact opposite of the desired effect of quantitative easing.
  5. Wrong message: QE2 may be perceived as an act of desperation instead of reassurance that the Federal government has the wherewithal to engineer an economic recovery.  This perception will undermine confidence in the economy, our currency, and dollar-denominated investments.
  6. Losses on Purchases: The Federal Reserve (i.e., taxpayers) might lose money on the bonds it purchases.  Taxpayers will ultimately make up the losses with higher taxes or the government will create even more money to “fix” the problem (i.e., throw gasoline on the fire).

Why More Quantitative Easing?

If the economy is no longer in a recession, why is this needed?  At the heart of the issue is a debate whether the forces of inflation or deflation will prevail.  Either one can cause considerable pain to our nation and its citizens, but in different ways.  Some economists forecast the economy slipping back into recession, causing deflation without the aid of additional monetary easing.  So, they advocate higher inflation.  Other economists see the economy as growing, albeit slowly, and foresee no need to take extreme measures to boost the economy.

Still, why pursue QE2 if it is untested and carries potentially harmful consequences?  One might infer that the “risk of ruin” from not engaging QE2 must be extremely dire, even catastrophic for the economy.  But, that’s not the case.  The intent of QE1, launched in early 2009, was to abate deteriorating financial markets and allow a suffocating economy to breathe again.  With round two, the situation is not about a panic, it’s about political risk of ruin.  An election is coming up next month and an even bigger one in two years.  Without significant, tangible economic progress, elected politicians are likely to experience a catastrophic event (from their perspective) come election time -- the death of their political careers.  So, despite the probability that QE2 won’t work any better than QE1, and despite the fact that printing money may create asset bubbles, fuel high inflation, cause high interest rates, and debase the U.S. dollar, politicians perceive those as acceptable risks compared to the end of their political careers.

The Likely Outcome

In our estimation, QE2 carries no guarantee for re-igniting economic growth.  There is already an abundance of cash available for spending and investment.  Interest rates are already at incredibly low rates.  Uncertainty about the economy, inflation, deflation, taxation, government regulation, and unemployment has businesses and individuals hunkered down.  Driving interest rates even lower will not change that situation.  Furthermore, the potential consequences of igniting inflation and causing interest rates to soar may cause prudent holders of cash to be even more cautious.

We believe that until the U.S. adopts sound fiscal and monetary policies, investments that benefit from a weakening dollar will do well.  Unfortunately, we don’t expect a shift to fiscal and monetary prudence anytime soon.  As a nation, we lack the political will, discipline, and willingness to make short-term sacrifices for long-term gains.

Investing Now

As your investment managers, the most important action in this uncertain situation is crafting an investment strategy.  Our job is not to make policy, but to anticipate and adjust portfolios based on what is taking place, regardless of the direction, reasons or intentions.  There is always uncertainty.  No matter how confident one might be about what will happen, no one knows exactly how this current situation will play out, nor does anyone know what the specific fallout will be.

In this instance, the potential outcomes and effects of QE2 may vary widely.  Prudent investors invest accordingly, not relying on one specific outcome.  So, we must abide by the second and third axioms of our four-point investment strategy --- diversification and moderation --- neither ignoring potential outcomes nor relying too heavily on false certainties of what will occur.

Our core mutual fund holdings are broadly diversified.  Within our existing holdings, the following investments could potentially prosper in the environment we envision:

  1. Bonds in fiscally sound countries with potential for currency gains, unlike mature, debt-laden countries like the U.S., Japan, and the U.K.
  2. Stocks of financially strong companies, domestic and foreign, with low debt and high cash flow, leadership in their industries, and minimal reliance on debt and the need to roll over existing debt.  The strongest get stronger in lean times.
  3. Income-producing investments will continue to be in high demand as the money supply is expanded until inflation wins the battle over deflation and interest rates rise. (Smart investing is additionally tricky given that interest rate movements can cut both ways.  When interest rates begin to rise -- they cannot go lower indefinitely, especially when already near zero -- the prices of income-producing investments will reverse course and their prices will decline.)
  4. Industrial Commodities like oil, copper, and timber (better investment merits than gold and silver).
  5. Inflation-indexed bonds and commodity-linked debt instruments that benefit from higher inflation and/or higher interest rates.

The veteran managers of our core mutual fund holdings are very cautious at this juncture.  This caution caused some of them to underperform their less cautious peers over the past year.  But we remind ourselves that the last time they were cautious and out of sync with peers was the late 1990’s when they sat on the sidelines during the internet and technology stock mania.  Although it was temporarily uncomfortable to “miss out,” it was absolutely the right thing to do and ultimately the more lucrative path to follow.

Our current portfolio stock allocations are lighter than the typical balanced mutual fund.  Despite the stock market’s impressive rise in September, we are not convinced that the associated risks are worth it or that current valuations are justified.  Compared to the typical balanced fund, our bond allocations tend to be in shorter maturities, less prone to price declines when interest rates rise.  We do not think seeking short-term gains, with a very real backdrop of potentially swift and large losses, is a prudent path for us to take.

Conclusion

Without a doubt, the coming years will be a time in which fortunes are made and lost.  None of our clients have asked us to make them rich, but many, many have asked us to help them not become poor.  Our investment strategy --- balance, diversification, moderation, and patience – is guided by our two-fold mission of profits and protection of capital.  There are times to be more aggressive and reach for high returns. We do not believe this is one of those times.

We are grateful for the confidence you have placed in us by allowing us to manage your investment portfolio.  Our pledge to you is that we will abide by our mission and do our very best to continue to earn your trust.   Thank you. ***

Greg Schultz & Bruce Grenke
© 2010 Asset Allocation Advisors, Inc.