INSIGHTS

On October 22, 2010

A Few Thoughts on Quantitative Easing

---

I want to share some basic thoughts on the Fed’s recent public discussion of reengaging their asset purchases. This is referred to by the markets as “Quantitative Easing” or “QE” as the Fed is intending to invigorate economic activity by increasing the number of investment dollars in the markets. The Fed’s directive is to maintain price stability as well as promote full employment. They believe that the current disinflationary trend in the United States could turn to longer term deflation. Economies that suffer long term deflation fail to grow as demand for assets drop when the perception becomes one of “I will wait to purchase since the prices are dropping.” Generally, the right amount of inflation (2-3%) causes prices to gently escalate over time avoiding the pitfalls of spiking inflation which destroys the purchasing power of a country’s currency. When consumers believe that asset prices will rise, they advance the timing of their purchase decisions and thus increasing economic activity.

I was always taught that the Fed writes the music that the markets dance to. At time periods when the Fed is accommodative, generally asset prices rise. When they are tightening, the punchbowl gets drained. You may recall hearing the term “never fight the Fed” which I have learned the hard way not to dismiss. The Fed has an unlimited amount of tools at their disposal and have expressed on many occasions the propensity to use them all until they see greater economic growth. We have seen this power most recently when the Fed purchased a trillion and a half dollars of Treasuries and mortgage paper. Where did they get 1.5 trillion dollars? Well they made them. The Fed seems convinced that more currency supply is needed and thus they are targeting another round of QE. When the Fed moves into the open markets and purchases financial assets for its own account it is pushing investment dollars out of Treasuries and into riskier assets. The move has the direct effect of holding down long term interest rates (decreasing the potential returns on Treasury assets), and it frees up huge amounts of money that must go find other assets to buy. That additional demand generally raises the price of other assets.

Some of the effects are a bit more subtle. QE also has the effect of creating a huge amount of additional dollars. In theory these additional dollars in the system tend to replace the ones lost to real estate or equity markets declines. This wave of new dollars can also have the effect of watering down the value of the dollar’s purchasing power. When huge amounts of currency are dumped on the world markets, it tends to dilute the purchasing power of the existing currency supply. The Fed knows this and is willing to assume the risks associated with the loss of purchasing power. You see, when assets are denominated in dollars and those dollars lose purchasing power, the asset prices rise to reflect the weakened state of the currency. This is what we are seeing in currency markets as the dollar continues to lose value against world currencies. At any other time one would postulate that QE is incredibly inflationary and if the Fed continued this practice for too long it would be. We think that the Fed will purposely overdo the stimulation in order to fend off any whiff of deflation.

Given our outlook on QE and its intended effects on the economy and asset prices, we have the following take aways:

1. We believe risk assets are cheap and will benefit from the investment dollars chased out of the Treasury markets as well as record money market balances. These include mid to lower investment grade municipal and corporate bonds. Duration should be minimized and credit risk should be extended. We also think real estate will be a beneficiary and investors should benefit from rising income streams over time. Stocks are really inexpensive and should be a major beneficiary of the flow of funds once the individual investor gets tired of no-yield money markets. Finally, the commodity run may be a bit extended on the short term but we don’t think we are done with the cycle. A weaker dollar and rising demand should continue to drive prices higher over the longer term. A small amount of commodities historically has been a great hedge for a bond portfolio.
2. What to avoid? It is our opinion that at some point, we will begin to experience higher interest rates as the Fed’s actions begin to increase demand for credit. Economic recoveries tend to be correlated with rising short term rates. I would not expect to see higher rates any time soon as the Fed is clearly trying to hold rates at record lows. We are not in the “U.S. as another Japan” camp and believe the Fed will be successful at creating a good deal of price appreciation (inflation). We believe this will become poison for bond fund investors and long-duration fixed income investments as interest rates will rise. That ride will not be a fun one. We believe keeping durations shorter and credit risk higher with a dab of commodities as a hedge should be a good combination.

In conclusion, it is important to note that this has not been done before to this extent by the Fed and will certainly be the subject of discussion for years to come. I am interested in your thoughts on the Fed’s recent actions.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.