September 16, 2012
This past Thursday the Federal Reserve announced QE 3, a program to buy $40 billion worth of Mortgage Backed Securities (MBS) on an open ended basis. The $40 billion in purchases will be in addition to the $45 billion in longer term securities being purchased through Operation Twist. In addition, the Fed announced an extension of its Fed funds target range of 0-0.25% through 2015. Effectively the Fed is attempting to artificially stimulate the housing market by reducing mortgage rates and push investors into riskier assets such as stocks by keeping interest rates exceptionally low for an extended period of time. With 30-year mortgage rates already at historic lows it’s unlikely that the Fed’s policy will be enough to spark a recovery. The problem isn’t that interest rates aren’t low enough. The bigger issue is that banks have now become exceptionally stringent in their lending criteria. Additionally, homeowners who are underwater in their loans also will not benefit. Thus, it’s unlikely the purchase of MBS by the Fed will be effective in materially improving the housing market.
It’s clear that both QE 1 and QE 2 failed to spark a real recovery in either the economy or the real estate market. The only tangible impact from the prior rounds of quantitative easing was a spike in the stock market. QE 3 will not be an exception. With markets rallying globally, the Fed was successful in its efforts to boost share prices at least in the short-term.
The question remains why did the Fed decide to launch QE 3 with the US stock market at a 4-year high, food and energy prices soaring and interest rates at historic lows? The only answer in my view is that they are in panic mode because the global economy is entering a new phase of the crisis that began in 2008. The only reason why inflation hasn’t exploded higher is that bankers are scared to lend. When the Federal Reserve engages in quantitative easing it creates money “out of thin air” and purchases assets such as government bonds or mortgage backed securities from banks or other financial institutions. The funds received by the banks can then be lent out as loans to customers or retained as excess reserves with the central bank. In the current environment, banks are too afraid of additional credit losses to lend money out. Thus, excess reserves continue to build-up.
Essentially, banks aren’t lending out their excess reserves because they are afraid of credit losses. Thus, money supply fails to increase because banks fail to expand credit through the fractional reserve banking process. Quantitative easing works by a central bank purchasing long-duration fixed income securities such as government debt, with newly created cash. As a result, the economy is flooded with cash that earns no interest. Thus, investors feel pressured to search for higher yields and speculate in riskier assets such as equities. In theory, the boost in the prices of speculative assets such as stocks is supposed to create a wealth effect that allows people to begin spending again. Clearly, with the failure of both QE 1 and QE 2 to stimulate the US economy, it’s clear that the wealth effect doesn’t work as expected.
Inflationary pressures were already high in the US and especially India. A direct result of the Fed’s actions will be even higher rates of inflation. With China facing a “hard landing”, the US facing a recession and Europe already in a recession, higher rates of inflation will only add to the negative factors impacting stock markets globally.
Indian equities have recently benefited from both the announcement of QE 3 and new FDI reforms in the airline and retail sectors. Given this new investment landscape it’s more important than ever to have the right asset allocation mix in your portfolio. I think it’s incredibly dangerous to be chasing the Indian market at current levels. You also need to be careful about adding positions to your portfolio as “risk-on” assets are sharply overbought. If you’re interested in learning more about an investment that will outperform despite the coming inflationary storm, you can sign up for the Value Investing India Report. To find out what we’re are currently recommending to our subscribers sign up (on an absolutely risk-free basis) for only $29.99 per month by clicking the following link.