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QE3: The Bad News

September 15, 2012 | About:

Gordon Pape

15 followers
The stock markets loved the Federal Reserve Board's aggressive attempt to kick-start the U.S. economy. Following Thursday's announcement, all the key North American indexes took off. The Dow finished the day up 206 points after lacklustre morning trading while investors waited for the Fed's decision. Nasdaq gained 41, the S&P 500 was up 23, and our own S&P/TSX Composite added 127 points as commodity prices rose. It was more of the same on Friday as the euphoria continued to drive prices higher.

Well, forgive me, but I don't share the enthusiasm. I think the Fed moves represent bad news for many investors for several reasons. Here they are:

The economy is in worse shape than we thought. It has been clear for some time that the weak global recovery that followed the 2008-09 credit crisis has been stalling. Europe is on the brink of tilting back into recession (several countries are already there), China has shown no sign of regaining its upward momentum, and U.S. growth is tentative at best.

In view of the controversy over the effects of quantitative easing (QE), both short and long term, it would have been prudent for the Fed to hold off introducing another round of what amounts to printing money. Many observers, myself included, thought Ben Bernanke and his team would at least wait until after the November election since QE is strongly opposed by fiscal conservatives and will certainly become a talking point for Tea Party candidates.

Mr. Bernanke told a news conference that the Fed's Open Market Committee does not take politics into account when making its decisions. That's smoke-blowing - you can't disassociate monetary policy from politics in the U.S., especially in the middle of a closely-fought election campaign. The fact the Fed decided it had to act now suggests the situation is deteriorating at a rate that would make further delay a dangerous gamble.

The official statement didn't say that, of course. Such a suggestion would have panicked the markets. The language was couched so as to indicate this is all about job creation. "The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions," the press release said.

It went on to make the point that the moves are open-ended - there is no time frame for turning off the money presses. "The Committee will closely monitor incoming information on economic and financial developments in coming months," the statement said. "If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability."

No one can recall a time when the Fed moved so aggressively on multiple fronts in what appears to be a non-crisis situation. It raises very sobering questions about what lies ahead.

It's inflationary. Commodity prices moved higher after the announcement and oil finished the week just one dollar below the $100 per barrel mark. The reason is simple. Commodities are priced in U.S. dollars. QE3 will effectively debase the currency which means it will take more dollars to buy a barrel of oil, an ounce of gold, a pound of copper, or a bushel of wheat.

This is good news for our sagging resource sector - producers will get more money for their output. But it is lousy news for consumers who can look forward to higher prices at the gas pumps and in the supermarkets.

The loonie will be pushed higher. Within minutes of the Fed announcement, the Canadian dollar moved to over US$1.03. It pulled back a little on Friday, but finished the week just over at US$1.03. Exporters wept.

Earlier in the week, Statistics Canada reported that the country's trade deficit in July came in at $2.3 billion, up from $1.9 billion the month before. Export volumes dropped 2% overall but particularly worrisome was the 5% decline in shipments to the U.S. Energy products led the way down with exports falling 8.5%. Machinery and equipment dropped 5.5% while automotive products were off 5.3%. And all this at a time when the loonie was lower than it is now.

Interest rates will stay low longer. The Fed isn't just printing money. It has also pledged to keep interest rates at or near current levels until at least mid-2015 - an extension from the previous 2014 time frame. This is discouraging for several reasons.

For starters, it means that savers will continue to struggle for the next several years. Interest rates on traditional safe haven investments such as bank certificates and government bonds will remain extremely low. This means income-oriented investors will face two unpalatable options: either to accept interest rates that may not even match inflation or to take more risk to chase yield.

Low interest rates are also bad news for pension plans, insurance companies, and banks. Pension managers hold a high percentage of their assets in fixed-income securities. A long period of low returns on those investments means the plans are falling short of actuarial projections, putting many of them in a deficit position in relation to their obligations. The ultimate result may be increases in contribution requirements, a reduction of benefits, or, worst case scenario, default.

Insurance companies and banks do better when rates are higher. In the case of insurers, high interest rates mean better returns on their investment portfolios, which are used to backstop their liabilities to policy holders. For banks, higher rates mean wider spreads between what they pay on savings accounts and GICs and what they can charge on loans. Wider spreads translate into higher profits - although based on the numbers the banks are posting this year they seem to be doing just fine even with interest rates at current levels.

The Bank of Canada will be hamstrung. Governor Mark Carney wants to raise interest rates. He has made no secret of that. Mr. Carney believes Canadians are seriously overextending themselves by borrowing too much money in this easy climate, putting households at risk if economic conditions worsen.

But there is not much he can do on the interest rate side as long as the Fed stands pat. Any upward move in the Bank of Canada's overnight rate would push the loonie even higher, which is the last thing anyone wants right now. If anything, the central bank may be forced to cut its key rate if the new open-ended round of QE3 continues to push up our dollar.

When you take all this into account, the only people who should be rejoicing at the Fed's decision are investors with heavy positions in gold and other commodities. The longer QE3 goes on, the more they are likely to prosper. Gold ended the week at US$1,772.70. We could see it closing in on US$2,000 an ounce next year.

So if you don't already own some gold, don't wait any longer. It's not likely to get cheaper any time soon.

About the author:

Gordon Pape
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.9/5 (10 votes)

Comments

Dr. Paul Price
Dr. Paul Price premium member - 1 year ago


Gordon,

I agree with everything you said except this...

"Any upward move in the Bank of Canada's overnight rate would push the loonie even higher, which is the last thing anyone wants right now."

Canadian consumers would benefit and should like a higher loonie as it would restrain import prices and their cost of living.

I agree that it makes Canadian exporting more difficult. Normal consumers wouldn't care much about that though.
traderatwork
Traderatwork - 1 year ago
Nope, not agree with most of the thing you said. Fed will be damn if they do(something), damn if they don't. Fed try to breath stability of interest rate hope to speed up the economy recovery, personaly I do not think it has anything to do with politics. What is your suggestion of saving the country? Stop injecting(printing money) in to economy? Increase interest rate?

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