About 10 days ago on September 20 2017, the Federal Reserve finally made the announcement that many dreaded, but ultimately knew was inevitable.
The Fed is finally stopping its Quantitative Easing Program and beginning what is being deemed ‘the Great QE Unwind’.
How great is great you ask? Well the Fed’s balance sheet currently stands at an astounding $4.52 trillion. That figure can be split roughly into Treasuries at $2.46 trillion and mortgage-backed securities (remember those?) of $1.77 trillion.
By the way that $4.5 trillion is just the Fed. Globally, when including the European Central Bank and Bank of Japan, the total is more like $14 trillion. The world has never seen an unwinding on such a scale, so when the Fed says the effect of the unwinding would be ‘quite mild’ and ‘only run in the background’, we should take that with a grain of salt.
After all, there is plenty of evidence to suggest that the QE program has been, to put it mildly, not quite as effective as hoped. As the St. Louis Fed economist Stephen Williamson said there is ‘no evidence that QE works’. First let’s take understand what the goals of QE were: inflation and real economic activity.
Williamson notes that since QE, there has been little difference in the economic conditions between the United States and Canada; a country that did not engage in any quantitative easing. Inflation in the US has also remained inexplicably low.
Moving on to ‘real economic activity’. Anyone who has been paying attention can tell you that the US economy is far from recovered. Sure, the stock market is constantly pushing new highs but does that count as real economic activity?
In fact, many are of the opinion that QE is the only reason that we have such an inflated stock market in the first place.
Here’s a simple explanation for how QE inflates the stock markets. Under QE, the Fed purchases treasuries and mortgage-backed securities. The sellers of those securities now had to replace them with other securities. Some of it went into corporate debt but some of it went into higher yielding securities, namely the stock market.
Essentially, QE resulted in lower yields on government securities (because the Fed was buying them up, prices increased and thus yields fell), and thus encouraged investors to adopt yield-seeking behavior. And what better place to seek yield than in the stock market? Numerous analysts have noted that as central banks’ balance sheets ballooned, so did the value of US equities and global risk assets.
Here’s how it matters to you: if QE has resulted in the best stock market performance the US has ever seen, what will the reverse of QE do?
The Fed has announced that it will unload about $50 billion a month (beginning October 2018) or $600 billion a year; can that amount really just ‘fly under the radar’?
Further, history has shown that financial tightening often results in the opposite effect, at least temporarily. When people know that interest rates are only going to keep going up, they go out and borrow as much as they can now. This results in bubbles, as seen in the January 2004 to July 2006 period where the federal funds rate increased from 1% to 5.25%.
A massive housing bubble formed during that period; we don’t need to tell you what happened after that.
So to conclude, what we have here is ‘reverse QE’, taking the air out of the pump that has been inflating the stock market all this while. In the meantime, the short term effects may well lead to other disastrous bubbles, especially in housing. A disastrous combination.
As Moody’s sums up: “markets often prosper during episodes of Fed tightening. However, painful sell-offs eventually materialize…”
It’s no surprise then that intelligent investors, taking all this into account, have decided to hedge their bets. But what can they hedge their bets with when the entire economy is at stake? The answer is precious metals. Precious metals, such as gold, have been used for thousands of years as stores of value and today still remain effective hedges and portfolio diversification mechanisms.
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