Friday, August 26, 2011

Q&A Series: Quantitative Easing’s Effect on the Stock Market

From the Desk of Joe Rollins

Uncle Ben to the Rescue? Probably not!

You may have heard a certain Republican presidential candidate spewing rhetoric that may lead supporters to believe the Federal Reserve is the devil incarnate. Rick Perry is calling any moves undertaken by Chairman Ben Bernanke to expand the money supply “treasonous,” a statement Sarah Palin agreed with during an appearance on Fox Business. (“printing more money to play politics at this particular time in American history is almost…treasonous in my opinion.”) Clearly, neither the Texas governor/presidential candidate nor the former half-term Alaska governor/Fox pundit has any idea what the Federal Reserve’s economic goals are or how it operates. I’m not saying they’re debauched, just uninformed.

The Federal Reserve System was created by Congress in 1913 after a series of financial panics. The role of the Fed has evolved over time, but its two primary goals are to maintain price stability and increase employment. The main way the Fed controls economic activity is through interest rates, under the theory that the lower the interest rates, the better the economy. If interest rates are low, businesses can borrow inexpensively, build plants and equipment, employ more people, and expand. Likewise, consumers can buy cars, TVs and other products and services with low interest rates and easy credit.

In 2008, the Fed reduced the Federal Funds Rate and the primary interest rate to almost zero. Since they couldn’t go any lower than that, in 2009 they began utilizing a less conventional technique to stimulate the economy – quantitative easing. This leads to today’s Q&A, as follows:

Today’s question comes from Mike, a client who is wondering about the effect of quantitative easing on the stock market.

Q: The Fed has instituted quantitative easing policies twice to stimulate the economy. Have those efforts artificially propped up the stock market?

Considering all the talk in the press that Fed Chairman Ben Bernanke may announce another round of quantitative easing (QE3) tomorrow during the Fed’s annual symposium in Jackson Hole, Wyoming – and commentary as to whether or not QE1 and QE2 were effective – this question is on the minds of many investors.

The Background

In simple terms, quantitative easing is when unconventional methods are used to pump money into an economy to drive down interest rates and encourage more borrowing and growth when typical monetary policy isn’t working.

In the U.S., the first round of quantitative easing, “QE1”, introduced “credit easing” – wherein the Fed purchased government-sponsored bonds, mortgage-backed securities and Treasuries, and recorded that it had done so. This is called “expanding the balance sheet”. This money is then made available for banks to borrow in the hopes that it will increase the amount of money in the economy and, therefore, reduce long-term interest rates.

QE1 ended in the spring of 2010, but the economy continued to waver. And so, in the fall of 2010, the Fed indicated that they would take on new quantitative easing measures in an effort to combat persisting high unemployment and low inflation – actions that came to be known as QE2.

QE2 was a different animal than QE1. Whereas QE1 utilized credit easing to increase money in the economy and reduce long-term interest rates, in QE2, the central bank reinvested proceeds from its mortgage-related holdings to buy Treasury debt and also purchased additional long-term Treasury securities. The QE2 efforts ended on June 30th, with economists giving it mixed reviews.

QE’s Impact on the Economy and the Stock Market

So, has QE provided any benefit to the economy? It’s hard to say for certain, and as stated above, economists’ opinions have varied on the subject. When the Fed buys bonds from the public and private sectors, one would intuitively think it would force interest rates down; and that when the Fed quits buying these bonds, it would force interest rates back up. On the contrary, almost exactly the opposite has happened.

When QE1 began, interest rates actually started to rise, although from a very low level and only to moderate rates. It was generally presumed by the markets and the so-called experts that as soon as QE2 was scheduled to end on June 30th, interest rates would almost assuredly skyrocket. In fact, since June 30th, the 10-year Treasury bond – the benchmark bond issued by the Federal government – has plummeted to 2%, a record low for the last 60 years. Oddly, quantitative easing actually caused interest rates to increase when implemented, and rates to decrease when the program stopped.

Politicians often speak of the Fed “turning on the printing press.” It’s true that the Department of Treasury has the ability to print new money, and therefore, it’s possible to produce new money to pay off old debts. In fact, quantitative easing’s effect was basically the same as printing new money without ever turning on the printing press. The Fed’s purchase of public and private sector debt instruments put tons of cash into the U.S. monetary system which, in theory, should have increased economic activity. This is what Governor Perry was criticizing as being political.

It’s a misconception by many Americans – including some politicians – that the monetary base is diluted when the Fed prints money. But as the above example indicates, even though printed money was utilized, the Fed actually purchased assets. There’s no net increase in assets owned by the U.S. by substituting cash for bonds – it’s a one-for-one transfer. The Fed simply has the bonds on their balance sheet which can be sold at any time and the cash put into the economy. It’s a form of putting excess cash into the economy rather than bonds in the hopes that people holding the cash will use it for the betterment of the economy. This method has been used by central banks worldwide throughout history.

For example, U.S. banks currently have $1.7 trillion in cash on deposit with the Federal Reserve. U.S. corporations are said to own over $2 trillion in cash that’s accumulated on their balance sheets. There’s no question that the monetary base has exploded by the Fed’s actions of taking money from its pockets and putting it into the pockets of consumers, companies and banks in the U.S.

Theoretically, once this money is in the system it will be utilized to create commerce. Unfortunately, this is where the theory has failed. In a nutshell, a combination of economic uncertainty, a distrust of Washington, and conservatism are causing U.S. corporations to refuse to spend their hoards of cash. Banks are covered up in cash right now, and the reason CD rates are so low today is because banks have little interest in more deposits since they received more than they could ever loan to the general public and businesses. Likewise, businesses are also covered up in money and have no desire to borrow from banks.

While approximately 10 million people in the U.S. would benefit from refinancing their mortgages to lower interest rates – which would, in turn, help the economy – banks are unwilling to lend to these potential borrowers – even those with good credit. This is a Catch-22 – money is everywhere, but no one is willing to loan it or utilize it due to the uncertainties. And although there’s a lot of talk of the potential for the Fed to go forward with another round of quantitative easing, (“QE3”), for the foregoing reasons, I just don’t think that announcement is in the cards for Bernanke’s speech this Friday.

Those who are critical of the Fed’s QE efforts thus far must remember that just as easily as they were able to put money into the system, they are able to remove it from the system. To do so, the Fed would reverse the effects of QE by selling the bonds that they currently hold on the open market and withdrawing the cash. To the extent that the Fed is holding Treasury bonds, they would simply force the banks to buy them and remove that cash from circulation. As such, if you believe that the Fed’s flooding of the economy with cash is a negative, the argument could easily be made that the positives far outweigh the negatives. But if the Fed doesn’t retire that cash and take it from the monetary system at some point in the future in an effort to shrink the money supply, it would undoubtedly be inflationary and would decrease the value of the dollar.

It could be argued that since the beginning of the Fed’s efforts, QE has been successful since it has kept interest rates very low; it has forced the value of the dollar down (helping exporters); it hasn’t created inflation in a broad sense to this point, and; it hasn’t diminished the value of most assets in the U.S. (depreciation). On the other hand, QE has been unsuccessful in that it created very little economic activity. In fact, the economy slowed dramatically during the period of time QE was in effect. It has also forced down the value of the dollar, increasing the value of all commodities. Oil and other needed commodities move inversely to the value of the dollar. This means that oil and commodity prices have increased. Higher gas and food costs are a drag on the U.S. economy in some way or another.

There are also those who argue that quantitative easing has made the stock market soar, but it’s hard to draw a direct parallel between quantitative easing and the stock market. There’s an indirect parallel in that quantitative easing was very successful in keeping interest rates low. With interest rates as low as they are, there’s virtually no incentive to buy interest-bearing certificates. For example, the dividend yield today for the S&P 500 index is actually higher than the 10-year Treasury bond yield. Therefore, if quantitative easing was successful in making interest-bearing certificates unattractive, then it could be argued that it’s inflated the stock market. However, the real reason stock prices are higher is because earnings are clearly superior and getting better. I’m not sure there’s any direct correlation to earnings being great and quantitative easing, and therefore, I question whether QE has caused higher stock prices. Perhaps the best answer is, “It depends.”

So, if you’re anticipating Uncle Ben to wave his magic wand on Friday and announce QE3, it’s unlikely that fantasy will be unfulfilled. My guess is that Bernanke, as always, will talk thoughtfully about the many options that are available to the Fed to stimulate the economy. But it appears that the moves in monetary policy to stimulate the economy are few and far between. Hopefully, Bernanke will state that they’ve done all they can do, and it’s now time for Congress to do something positive. But I wouldn’t count on that, either – they’ve already proven themselves to be incompetent.

My guess is that rather than Bernanke announcing QE3, he will simply extend the maturities on the bonds held by the Federal Reserve which now amount to $2.7 trillion, successfully reducing long-term interest rates. Since a change of that nature would be subtle and doesn’t constitute a direct intervention in the economy, I suspect we’ll see a market sell-off on Friday following Bernanke’s speech since the traders will want much more.

At the end of the day, none of Bernanke’s comments have much effect on the stock market. Rather, the stock market is driven by the economy and corporate earnings, and all this talk is distracting. Even though the stock market has sold off 15% from its high, as of today, nothing has changed fundamentally. Corporate earnings are still extraordinarily high and interest rates are extraordinarily low. Gold is now selling off and is correcting, and interest rates are starting to rise. Each and every one of these indications almost assuredly indicates a higher stock market in the future.

While the traders are working their way into a frenzy over what Bernanke will potentially do, none of it will really matter come next week since it’s earnings that control the stock market’s future. Currently, our future seems to be better invested in stocks than anywhere else.

Thanks for your question, Mike. We’ll have to wait and see if the Fed has decided to go forward with QE3 this Friday when Bernanke speaks at the Jackson Hole symposium – and what the market does after his speech.

We encourage our clients and readers to send us questions for our Q&A series at And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins