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It's happening people, QE-3 has been implemented by the Federal Reserve Bank. Earlier today, the central bank announced that they will continue their Operation Twist' program into the end of the year. They will also keep the fed funds rate (overnight lending rate to the large banks) at zero percent until mid-2015. The real bazooka was when they said that they will buy $40 billion worth of mortgage back securities every month. Finally, to put the icing on the cake, the central bank also said that they will add to purchases if the labor market does not improve. It sounds like they want to create another housing bubble the way they did in 2002 – 2006. In any case, the stock markets have rallied sharply higher on the news.
There are massive stimulus programs now taking place in the United States, Europe, and China. The world's largest central banks are inflating markets on unprecedented levels. Traders and investors must remember, for every action there is an equal and opposite reaction. The last time this type of inflation was created the markets faced the worst recession since the Great Depression. The next one could be similar or even worse should this easy money continue. While a disaster may not occur for quite a long time, the equal or opposite reaction will likely happen at some point down the road if history serves us correctly.
What happened today? Well, today President Obama was basically reassured to win reelection. Remember, higher stock market prices often mean that the incumbent will be reelected. The only negative that could hurt President Obama at this time is the high fuel and food prices that will come from all of this stimulus.
Leading equities such as the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), SPDR Gold Trust (ETF) (NYSEARCA:GLD), iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), and almost everything else is soaring higher today. While this stock market is severely overbought it has not seen this much stimulus since early 2009.
QE3, or quantitative easing 3, lingers in the back of investors’ minds.
Few investors seem to know exactly what quantitative easing really means.
We’ll take the time to explain it now.
QE3 Explained
Quantitative easing is a simple concept: a central bank “prints” money to buy long- and short-dated government debt. The goal is to drive down interest rates, boost demand for investment capital, and increase economic output.
Supply and demand are equally powerful forces in the currency and debt markets as they are in the market for shoes, toothpaste, or jelly beans. Increasing supply means lower prices. For currency, the price is not only the current price, but also the future price—interest rates.
Many think that quantitative easing 3 will never come. The Fed has agreed to make the market for dollars liquid with a promise to keep interest rates at 0-.25% for the next two years. That action alone should keep the price of money inexpensive enough to end all talk of QE3.
Effects of QE3
We can’t predict with certainty what the Federal Reserve will do to boost output, stave off deflation, and promote general economic growth. However, we can explain how QE3 will affect the markets, pending that it does eventually come:
- Lower Treasury Yields – The Federal Reserve is authorized to buy US Treasuries with freshly printed dollars. When the Fed bids up the price of US Treasuries, the yield on US Treasuries moves down. This is true for any bond—price and yield are inversely-related.
- Lower dollar value – By nature of any quantitative easing program, the Fed must create more dollars to buy up US Treasuries. Naturally, this results in a lower dollar value against other currencies, as the price of the currency is dictated primarily by supply and demand.
- Inflation concerns – It happens every time the Fed acts to loosen monetary policy. Inflation remains low in the US, but a small group of investors worry that quantitative easing will lead to inflation. The reality is that the Fed would like to see inflation, since it has thus far failed to create any real measurable amount of it. Deflation remains a top concern.
- Rising asset prices – Assets are priced into the future, whether we’re talking about stock prices, or the price for a barrel of oil. When the time value of money falls, investors can pay for earnings further out into the future. Bernanke made it clear his goal was to boost the financial markets, and that means giving lift to asset prices.
See? Economics doesn’t have to be difficult to understand!
When looking at the Fed’s options for tomorrow, there are about three outcomes that are most likely and each will create its own market reaction.
Scenario 1: The Fed introduces QE3 to the world with the promise to purchase $850 billion of longer-term Treasury securities.
Scenario 2: The Fed introduces QE3 to the world with the promise to purchase less than $500 billion of longer-term Treasury securities.
Scenario 3: The Fed does not introduce any form of QE3 and again repeats the mantra that they are frustrated with the current pace of growth of the economy, but isn’t bad enough for them to use such an extraordinary monetary policy tool such as Large Scale Asset Purchases.
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