Originally published on RGJ.com’s website http://www.rgj.com/story/money/business/2014/11/16/robert-barone-investors-worry-qe-ended/19080941/
As October ended, the Fed announced an end to its controversial money printing policy, known as QE3 (the third round of quantitative easing). In QE3, the Fed purchased large quantities of U.S government securities. When the Fed purchases bonds, it creates new money in the form of bank reserves.
For the past five years, the liquidity created by the Fed via this process has found its way into the equity markets, causing the Standard & Poor’s 500 to triple from its March ’09 low of 676.53 to 2,039.33 as of the close of business on Thursday. One thing of note in this particular business cycle is that rising equity prices go hand-in-hand with the growth of the Fed’s balance sheet. So, now that this phase of QE has ended, should investors be worried about the values of their equity holdings?
There are several important factors to consider: The strength of the U.S. economy; falling gasoline prices; and weak foreign economies prompting QE by foreign central banks.
The strong U.S. economy
Nowhere else is the strength of the U.S. economy more evident than in the labor markets. October’s net new job creation was 214,000; and with revisions to the back data, that marks the ninth consecutive month of job growth of over 200,000. We haven’t seen a run like this since ’94-’95. The unemployment rate now sits at 5.8 percent, a rate we haven’t seen since July ’08. And even the Fed, which has used the labor market as an excuse to keep interest rates low, acknowledged in its October FOMC statement the labor market slack they were worried about has all but disappeared.
The weakness in the world’s other major economies has driven oil and gasoline prices to levels not seen since 2011. Gasoline prices under $3 per gallon will benefit consumers and most businesses. Think about the benefits to airlines and transportation industries, and to retail trade as consumers end up with about $1 billion of annual discretionary funds for each 1-cent decline in pump prices.
The impact of foreign QE
For those worried about interest rates rising now that QE has ended, don’t. The Fed is committed to easy money for several more quarters. But, more importantly, the economic weakness in the rest of the world will cause foreign central banks (Bank of Japan, European Central Bank, and even the People’s Bank of China) to embark upon their own QE rounds. And, because the dollar is the world’s reserve currency, QE at foreign central banks has a similar impact on bank reserves and on our equity markets as if the Fed had done it directly.
Here is how it works. Since the ’90s, international trade has grown with 90 percent of that trade done in dollars. The large U.S. trade deficits for the past 20 years have created a deep pool of U.S. dollars, outside of the U.S. economy, operating to facilitate world trade.
Now let’s say the Bank of Japan wants to spur its economy by having its domestic businesses export more. To do so, it has to weaken its currency. So it prints a large amount of yen and sells those yen in the foreign exchange market for dollars. Through demand and supply, it has weakened its currency. In order to make a return on the dollars it now holds, the BOJ buys U.S. government securities, usually from one of the big Wall Street banks. When the funds clear, suddenly there are more dollars owned by U.S. banks on the Fed’s balance sheet. The money has been repatriated from the large international U.S. dollar pool, and the result is the same as if the Fed were still doing QE. In addition, the foreign demand for U.S. government securities keeps our interest rates down without our Fed having to lift a finger.
As long as the major foreign central banks are printing money and the dollar remains the world’s reserve currency, the result will be similar to our own Fed doing QE. Under these conditions, interest rates aren’t going to suddenly rise, and there will be plenty of liquidity to keep the equity environment positive, especially now the pesky idea of a “correction” has passed. Remember, the QE policies are experimental, and we don’t have any idea of when or how these experiments will end. I expect that eventually they will end badly — but not anytime soon.
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee. Robert is available to discuss client investment needs. Call him at (775) 284-7778.
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