Those that understand history know that the end of an era is generally not brought about by a single event, nor does it occur at a single point in time. It is a process.
The process of gradually winding down QE asset purchases, and the subsequent attempt by the US Federal Reserve to engineer a climb-down from the towering mountain of excess liquidity that has accumulated in the financial system, will mark the end of an extraordinary era in US economic and financial history. This will not happen in a day. This will be a process that will take at least two years -- and perhaps many more.
As I explained to subscribers of my newsletter on Wednesday, the coming era of transition will be extraordinarily difficult for investors. In this article, I will expand on this basic insight.
The Era of QE: Easy Money
Beginning in late 2008, the Fed embarked upon an experimental policy of asset purchases known as QE (Quantitative Easing) of unprecedented proportions, ostensibly in order to avert collapse of the US financial system and economy. I was at that time a strong supporter of these policies (QE1 and QE2), because as the demand for liquidity spiked during the financial crisis and Great Recession, the US FED effectively supplied the financial system with needed liquidity without compromising price stability or US the credibility of monetary institutions.
Indeed, I believe that there can be little doubt that the Great Recession would have been far worse, and structural damage to the US financial and economic system would have been far greater, had it not been for the Fed's decisive actions, particularly in 2008 thru 2010.
However, starting in September of 2011 with "Operation Twist," and later in August of 2012 with QE3, I believe the Fed began to lose its way. At that time, I voiced strong opposition to these policies, believing that the US Fed was digging the US economy and financial system into a deep hole that was going to prove very difficult to climb out of.
Excessively easy money was a boon for many while it lasted. But just as QE has conferred significant benefits to the US financial system and economy, it has also entailed the shouldering of very significant deferred costs. On Wednesday and Thursday we for the first time experienced just a hint of the sort of financial markets instability that the coming era of "withdrawal" is going to be characterized by.
The Era of Withdrawal
As the Fed gradually curtails and eventually ceases asset purchases, long-term interest rates -- which have been artificially repressed by Fed purchases of long-dated treasuries and agency securities -- will inevitably rise towards levels that are more consistent with the true level of demand for these securities in the marketplace.
This process of "withdrawal" does not have to be as disastrous has many bearish pundits have claimed. A variety of different scenarios are possible. People can reasonably argue about the nature, extent and timing of the inevitable monetary adjustment that must come and the price that it will extract. But make no mistake: A significant price will be paid in terms of long-term economic growth and stability.
I have described the difficult dilemma facing the Fed and the US economy as being between a bubble and a hard place. To a greater or lesser degree, US financial markets will likely be characterized by wild oscillations between price surges in some assets such as stocks and ETFs such as S&P 500 SPDR (SPY), SPDR Dow Jones Industrial Average (DIA) and Powershares QQQ (QQQ) that might be beneficiaries of declining liquidity preferences, and destabilizing price declines in fixed income assets such as long term treasury bonds (TLT) and high yield corporate bonds (JNK) that will be negatively impacted by the withdrawal of the Fed's artificial repression of long-term interest rates.
The end of the era of QE era of easy money is upon us. The highly volatile market action during this past week in which markets rallied strongly on Monday and Tuesday and then fell sharply on Wednesday and Thursday are just a small taste of what is in store for investors and traders in the next couple of years.
Fasten your seatbelts.