Fed Announces $600 Billion QE2; Holds Rates Steady

Quantitative easing leads advisors to assess impact on client portfolios

An earlier FOMC meeting in Washington. An earlier FOMC meeting in Washington.

One day after the midterm elections handed control of the U.S. House back to the Republicans, the Federal Reserve's policy makers agreed Wednesday to keep interest rates at historic lows and to maintain its policy of reinvesting principal payments from mortgage bonds and other debt into Treasuries.

The Federal Open Market Committee (FOMC) voted to buy $600 billion of longer-term Treasury securities by the end of second-quarter 2011 and to maintain the target range for the federal funds rate at zero to 0.25%. With inflation rates too low for comfort, the Treasury debt purchase program’s objective is to inject enough liquidity into the economy to get it moving at a faster rate.

“To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities,” the FOMC announced in a statement. “The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.”

For advisors and investment managers, the FOMC’s decision has left them wondering whether the Fed’s continued printing of money via debt purchases—because it can’t set interest rates any lower—will have the intended effect of setting the U.S. economy on course by encouraging job creation and business investment.

David Kelly, chief market strategist at J.P. Morgan Funds, was skeptical. He noted

that the economy had already showed signs of improvement in 2010, and that both stock prices and interest rates are likely to trend up anyway in the next year. The bigger question, Kelly said, is the uncertainty that the FOMC’s move will create.

“This economy is not suffering from a lack of liquidity,” Kelly said. “There is not a single home-buyer or business-person in America who’s hesitating to buy something because interest rates are just too high. Attempts to hold interest rates at even lower levels don’t really have much impact on the economy. I do think that the wording of the Fed’s statement today leaves a good deal of further uncertainty.”

The Fed’s purchases of securities over the next eight months will exceed what the total federal deficit will be over that period, Kelly asserted.

“If we’re running the federal government on the Federal Reserve’s credit card for the next eight months, what happens when the Fed takes its credit card away?" Kelly said. The problem, Kelly said, is that "QE2 sets up either the possibility of QE3, because they won’t want the economy to go cold turkey, or else a pretty sharp reaction in the bond market when people realize that this is the last of the help from the Federal Reserve,” he said.

Looking at investors’ portfolio construction in light of the FOMC’s decision, Kelly advised going long stocks and short bonds.

“If you believe that the economy will continue to recover gradually, with or without the help of the Federal Reserve, then relative to a normal portfolio, we think people should be overweight stocks and underweight fixed income. Of course, nobody is, but we think they should be,” he said.

Ray Humphrey, senior vice president with Hartford Investment Management Co. and portfolio manager of The Hartford Inflation Plus Fund (HIPAX), said the Fed’s Treasury buyback program is an incentive for investors to take more risk. By increasing

the money supply by $600 billion, Humphrey said, the Fed has effectively introduced $600 billion of new money supply that has to chase a finite amount of assets.

“Some of that money will go into cash, no doubt about it,” he said. “But most of that money is going to go into stocks, bonds, high-yield debt and everything in between. By increasing the money supply, what the FOMC has effectively done is to create asset price inflation. That is one of their objectives, to make households and companies a little bit wealthier so that they can increase spending, or aggregate demand.”

While Humphrey’s group is “very positive” on riskier asset classes, one of the asset classes that might be going under the radar is U.S. Treasury inflation-protected securities, or TIPS, he noted. “If the Fed is successful in creating higher inflation, TIPS will do better than Treasuries,” he said.

Jonathan Krasney, a fixed income specialist at his eponymous RIA firm in New Jersey and Florida, Krasney Financial, agreed that TIPS offer inflation protection—which is why they recently came to market with a negative 0.55% yield.

Ben Warwick, chief investment officer of Quantitative Equity Strategies in Denver, observed that while the U.S. government may be able to control rates with monetary policy, it can’t force a bank to make a loan to a company.

“We’ll likely see credit spreads between corporate and Treasury debt staying where they are on the corporate side,” Warwick said. “You’re going to get a pickup in yield on the corporate side. There are still probably some opportunities in fixed income, but at the end of the day this whole thing is a wealth transfer between the public sector and the private sector. Companies will be able to take advantage of the environment by issuing more debt. You’ve got a lot of companies with a lot of cash on hand. For example, Apple has a ton of money. They want to borrow it while they can borrow it.”

Read about quantitative easing and the Treasury bubbleat AdvisorOne.com.

For another viewpoint, read A Bond Bubble? FundQuest CIO Clift Begs to Differat AdvisorOne.com

Go here for links to an Oct. 15 Ben Bernanke speech on monetary policy in a low-inflation environmentand the FOMC’s Sept. 21 rate decisionat AdvisorOne.com.

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