I recently read an article on a business news website other than Seeking Alpha that sought to explore why people in the investment industry do not like the Fed's balance sheet expanding quantitative easing (QE) stimulus program. Given my strong disagreement with the content of the article, I was compelled to explore the real reasons why so many in financial markets have disdain for QE.
The Business Insider article that was also headlined on Yahoo Finance was baffling for several key reasons. First, in trying to explain why certain investors do not like QE, the author never bothered to talk to anyone who actually feels that way. Instead, the author decided to contact the likes of Paul Krugman to try and understand the scorn for current Fed policy. Thanks for the perspective, but perhaps the author should have entitled his article "Why People Who Love QE Think People Hate QE." Of course, such an approach does not answer the underlying question at all. Thus, a great deal of clarity on this point is needed.
One key topic needs to be clarified right up front. Just because you dislike the Fed's approach to monetary policy DOES NOT mean that you hate Ben Bernanke. I'm not sure when we arrived at the point in this world where people could no longer come together and engage in vigorous debate on policy differences without having to personally dislike each other. In fact, I have a great deal of admiration for Chairman Bernanke and his service to our country, as I do not envy at all the burden of responsibility that he has had to carry over the last several years in trying to carry out what he believes is the best course of action in trying to guide the global financial system out of what was the worst financial crisis since the Great Depression. And I genuinely believe that he is pursuing what he believes is the best possible course with his policies to address the extraordinary issues we continue to face today. With all of this being said, I have very strongly disagreed with his policy approach since the summer of 2010 when the Fed effectively announced the launch into QE2. But although I differ with him on policy, I still respect him as a person in his role of Chairman of the U.S. Federal Reserve.
Now that we have that point out of the way, it is worthwhile to explore some of the reasons that people do not like QE from someone who shares this opposing sentiment.
Dictating The Allocation Of Capital In The Economy
First, a primary objection I have with QE is that it results in a government policy making and regulatory institution in the U.S. Federal Reserve directly determining how private sector capital is being allocated. The Fed operates under a dual mandate of maximum employment and price stability. Recognizing the close relationship between these two objectives, the Fed has often emphasized that full employment can be best achieved through the pursuit of price stability. This is accomplished through overseeing the banking system and managing the U.S. money supply through monetary policy. But in recent years, the Fed has dramatically expanded its policy scope into areas that are normally the territory of fiscal policy. This has included specifically targeting selected areas of the economy such as the U.S. housing market including the aggressive purchase of mortgage backed securities (MBS) since the outbreak of the financial crisis. This has also included explicit statements of support for selected financial market segments such as stocks (NYSEARCA:SPY) and equally explicit statements of derision for other segments such as commodities (NYSEARCA:DBC) and precious metals such as gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV). More recently, the Fed's dialog has ventured into such far-reaching topics as income disparity and how wealth might be more evenly distributed across the economy. While all of these objectives are certainly virtuous and I commend the spirit behind their intent, focusing on such goals is simply not part of their job. And even if they are doing so in order to compensate for the lack of fiscal policy action on these various fronts, it's still not their job and by doing so they have in the process enabled fiscal policy makers to dither instead of act, which only compounds the problem. And by undertaking responsibility in this regard, they are ultimately making decisions that are resulting in direct benefits for some at the expense of others.
Helping Some Market Participants At The Expense Of Others
This leads me directly to the second reason why I do not like QE. By effectively locking interest rates at 0% since December 2008, the Federal Reserve has elected to provide direct and generous support to financial institutions and risk takers, some of which directly contributed to the cause of the crisis. Unfortunately, this subsidy is being funded by effectively taxing the income generating capability of the millions of Americans who are either retired or living on a fixed income, many of whom acted responsibly leading up to the crisis and are trying to continue to do so to the best of their ability today. While some of these individuals may count themselves among the fortunate who have been able to benefit from the "wealth effect" that the Fed is still seeking to create, most others cannot and are now being forced to look elsewhere to try and survive.
Forcing Many To Take On Inappropriate Risk
The third reason I do not like QE is because it has forced Americans who had planned their lives and retirements around the ability to generate high quality and safe rates of return to now take on extraordinary risks to achieve these same goals. Remember when not that long ago the risk free rate provided by 3-month Treasury bills was between 4% and 5%? Today, retirees who had to abandon short-term U.S. Treasuries (NYSEARCA:SHV) and FDIC insured CDs a few years ago must now venture far out the risk curve to categories such as high yield bonds (NYSEARCA:HYG) and dividend paying stocks (NYSEARCA:DVY) to achieve these same yields. Unfortunately, many of these investors are not at all acquainted with the capital risks associated with this reach for yield that they have effectively been forced to take as a result of Fed policy. And while people can talk a good game about how they are willing to endure the price volatility that is bound to occur along the way, it is an entirely different story when your retirement investments have lost -35% of their value in six months time just as high yield did in 2008. Moreover, while high yield and dividend stocks managed to bounce back in the aftermath of the financial crisis, what if it is unable to the next time around? What are those who are retired and living on fixed incomes do then? And all because the Fed was taxing them to try and help someone else.
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Pushing Market Prices To Widely Deviate From True Equilibria
This brings us to the fourth reason why I dislike the Fed's QE programs. By flooding financial markets with liquidity, it has completely distorted the true price setting mechanism across all asset classes. Where would stocks be today without the continuous support of the Fed and other global central banks over the last five years? Many believe that it would be lower, but exactly how much lower? Is it down -100 points on the S&P 500 Index? Or perhaps it's -700 points? Investment professionals can debate this point at length based on valuation and other metrics, but we simply will not know until the Fed finally withdraws the punch bowl. How about bond yields? Presumably they would be significantly higher than where they are today, but how much so? Would it be +3 percentage points on the 10-Year Treasury yield? Perhaps +5 percentage points? Or maybe since the underlying problem plaguing the global financial system is deflation, would Treasury yields actually be lower than they are today under QE? Once again, while these points can be hotly debated, we simply have no way of knowing until the Fed steps away. And this fact alone makes it extremely difficult to establish a disciplined long-term investment strategy and asset allocation, as even the highest quality asset classes can no longer be considered completely stable or predictable. Nor are they any longer sufficiently compensating investors for the long-term risks associated with their allocations in many cases.
Promoting Short-Term Trading In Place Of Long-Term Investing
This leads us to the fifth problem I have with endless QE. It has forced many investors across all different philosophies and disciplines to significantly shorten their time horizons and holding periods associated with their investments. Prior to the financial crisis, I held positions in high quality names such as Exxon Mobil (NYSE:XOM), PepsiCo (NYSE:PEP), Procter & Gamble (NYSE:PG) and Emerson Electric (NYSE:EMR) continuously for over a decade. In addition, I personally held shares of General Electric (NYSE:GE), AT&T (NYSE:T) and Kimberly-Clark (NYSE:KMB) that were first purchased in 1933, 1954 and 1979, respectively, and were passed down through family generations. I long believed that I would likely own many of these core positions for decades to come if not forever, but I was forced to part ways with nearly all of them in the years surrounding the financial crisis. And while I have restored some of these positions in the years since, I own them with the complete recognition that they may need to be liquidated at a moment's notice ahead of the next flash crash or change in tone from a Fed official that suddenly sends the market into its next freefall. After all, who can forget the -37% intraday plunge in the price of Procter & Gamble on May 6, 2010, highlighting the fact that even the bluest of the blue chips may suddenly find itself in the midst of a major financial accident at any given moment. Such shortening of investor time horizons is not constructive for the long-term sustainable health of financial markets.
Markets Driven By Fed Words Over Fundamentals And Technicals
Which brings me to the sixth reason why I have contempt for QE. The daily direction of financial markets is no longer driven by economic or market fundamentals. Nor are the forces of technical analysis explaining market prices the way that they once did. Instead, investment markets are now almost entirely at the mercy of what Chairman Bernanke or his associates on the Federal Reserve might say or not say on any given trading day. This fact alone greatly undermines the ability of institutions or individuals to effectively implement an investment strategy, for we all must now be fully prepared for the market to turn decisively for or against us the moment a Fed member opens their mouth and regardless of whether the underlying fundamentals and technicals associated with our positions make sense or not. Chairman Bernanke's testimony before Congress on Wednesday and the violent market swings resulting from a few sentences uttered along the way provided the most recent stark example of this point. Portfolios that are effectively at the mercy of what a single person from the government might say or do on any given day greatly undermines investor discipline, as it pushes participation in financial markets toward a capricious game of chance. Such are not the characteristics that will foster confidence among existing investors and lure those who left back into the markets.
Not Allowing The Economy To Cleanse Itself
Lastly and even more broadly than investment market forces, QE has the detrimental effect of not allowing the economy to cleanse itself. It seems to have become an objective of monetary policy over the last several decades to resist any kind of economic slowdown whatsoever under the misguided notion that the economy no longer needs to go into recession. But this persistent emphasis misses the very important point that recessions are actually good for an economy. This is due to the fact that it forces an economy that has become sloppy with the excesses from the previous expansion to work these excesses off and reallocate capital more efficiently. Recessions induce an economy to get back into lean fighting condition, which helps establish a strong foundation for the next phase of growth. None of this implies that the Fed should allow the economy to fall into depression, which is why I fully supported the Fed's QE1 program back in late 2008 and early 2009. Moreover, it also does not mean that the Fed should not do its part to support the economy as it goes through this cleansing process. But by repeatedly working to prevent the U.S. economy from ever entering into recession, or checking stocks from going down for any sustained length of time for that matter, the market system is not being allowed to undergo the cleansing process it so badly needs at this point. This effectively results in the continual postponement of what so many believe is the inevitable and increasingly sharp correction for the economy and markets that potentially lurks around the next corner, which serves to undermine confidence and only puts off even further into the future the eventual real recovery that so many are yearning for at this point.
Most that oppose QE are not wicked. They do not wish ill on Chairman Bernanke. Nor do they want to see the market crash so that they can feast on the carnage. Instead, most market participants that object do not like QE because they believe it is greatly undermining the proper functioning of the market system. In short, QE is making things worse, not better. Nearly all of us want the global economy to recover and investment markets to sustainably thrive. And those who oppose QE believe that continuously flooding the financial system with liquidity is doing far more harm than good in trying to achieve this goal. It is effectively inserting the government into investment markets. It is taxing certain market participants and forcing them to take on more risk than is appropriate in an ongoing attempt to support others, some of which were direct contributors to the crisis that caused the problems with which we are still dealing with today. And instead of promoting greater market stability, QE is distorting prices across many market segments and encouraging a more reactive short-term approach to portfolio management. In addition, the fact that markets are increasingly driven by the words spoken by Fed policy makers over underlying fundamentals and technicals only adds to the distrust. Until policy makers finally allow the economy and markets to cleanse themselves and find their true equilibria, this post crisis period of uncertainty and instability will persist. And this will occur no matter how much the stock market is artificially inflated in the process along the way.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.