INSIGHTS

On April 25, 2011

QE3 on the Horizon?

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Everyone is very much concerned about what happens when QE2 (Quantitative Easing) ends. On one side of the aisle are the folks that believe that when QE2 ends, long term interest rates on Treasuries will spike as the largest buyer exits the market. They believe that the Fed may be tempted to generate QE3 in order to continue try to keep interest rates down and keep the fragile economic recovery going. Their argument is that a continuation of QE2 is stoking the fires of inflation as well as debasing our currency.

On the other side of the aisle, there are folks arguing that the yields on the Treasury bonds will drop even as the Fed exits and despite the fact that they are the largest holder of U.S. debt following a slowing U.S. economy during the first quarter. They argue that a weaker dollar is needed to correct the imbalance that has made the U.S. less competitive in world markets. They note that some inflation is ok and that we should not be concerned with fleeting spurts of higher prices. They argue that QE has been good for asset prices in the U.S. even though we are manipulating down the value of the dollar. They agree with the Fed that any ensuing inflation could easily be stopped with tightening monetary policy.

We think that over analysis of the situation may be more academic than practical. We would tend to be realists and look to understand the most likely outcome of what the Fed is doing rather than what we think they SHOULD be doing. We believe that prudent investors should never fight the Fed. The current actions by the Fed have created velocity and liquidity in the markets with still very little evidence of inflation being passed through to the public. The yield curve is very sharply positive, which generally tends to accompany economic expansion. Longer term interest rates are still well contained which tells us that debt investors still have little concern over inflation in the longer run. As long as these indicators are positive we would argue that the current trend is your friend. We always have to caution that markets can and will correct. Investors should expect this as it is healthy to support higher prices in the future. Will there be a QE3? We don’t really know at this point, but we believe the Fed continues its strong commitment towards supporting the economic recovery in the U.S.

Our conclusion is that even though it is important to know the potential outcomes of economic and monetary policy (the what if’s), it is more important to be an astute investor. The guideposts still point towards higher equity and commodity prices and continued low rates, in our opinion. We constantly look for change in these guideposts, but know that many times patience rewards the investor the most.

Here are a couple articles supporting our view:
• Jim Grant: Bernanke Has Unilaterally Added a Third Fed Mandate That Guarantees QE3 (Business Insider – April 24, 2011)
• Why the Fed Must End QE2 on April 27th (Business Insider – April 24, 2011)

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