A Stimulus-Crazed World

Can central bankers reflate the world to prosperity? Probably not, but that still hasn’t stopped them from trying anyway. 

The Federal Reserve’s unveiling of QE3 with no scheduled ending is generally the same path being forged by Europe, China, Japan and Brazil. It’s a last ditch effort in a vicious cycle of too much credit, too much spending and not enough common sense.

Along the way, ETFs linked to stocks, bonds, real estate and commodities have surged. How much longer will this continue? How can advisors protect and grow client assets? 

It’s no secret that central banks around the globe are taking aggressive steps to ease monetary policy and bolster their economies. In Europe, the ECB introduced a plan to buy unlimited quantities of bonds from troubled eurozone members. The Bank of Japan increased its asset purchase program to 80 trillion yen. The People’s Bank of China has cut benchmark interest rates twice since June to encourage bank lending and increase liquidity. 

This type of inflationary behavior is not without consequence. In the short run, it may provide some temporary relief. But the longer-term ramifications are higher prices and market instability. It’s important to understand where the puck is headed, before it gets there. 

The introduction of “QE” or “quantitative easing” into the common person’s vernacular began with the 2008 financial crisis and the “Great Recession” that followed it. The Federal Reserve’s objective in keeping interest rates artificially low and making large scale asset purchases was to help the broader economy. 

Before the financial crisis, the Federal Reserve’s balance sheet was large but manageable. Today, the Fed’s balance sheet has jumped from $900 billion in 2007 to almost $3 trillion today. 

Past versions of QE worked like a charm because they calmed fragile markets from falling into a sink hole. QE3, however, is not like the others. It came just as stocks crossed above their multiyear highs and, for that reason, is far more subject to the law of diminishing returns. Has the Fed overplayed its hand? And if it has, who will bail out the Fed, if and when, the chickens come home to roost? 

The stability of central banks shouldn’t be taken for granted. The Fed was born in 1913 as a result of the Panic of 1907. It is actually the third central banking experiment in the U.S. Its predecessors were the First Bank of the United States (1791-1811) and Second Bank of the United States (1816-1836). Put another way, the history of central banks is shaky, which rightly makes us question their future viability.

QE Rewind 

QE1 began in 2008 and was followed by QE2, which involved the Fed buying around $75 billion a month in government bonds. In 2011, Operation Twist was introduced and led to the Fed’s $400 billion switch from short-term Treasury bonds into long-term Treasuries (TLT). How did markets react?

The S&P (SPY) rallied 37% from the first installment of QE1 (Nov. 2008) and 51% from the expanded QE1 (March 2009) to the end of QE1 (March 2010).

The market was already extended when QE2 went live, but was still able to add another 11% until QE2 ended on June 30, 2011.

After the QE3 announcement, the S&P jumped again and is less than 10% away from its all-time high of 1,565 set on Oct. 9, 2007.

Assault on Wealth