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The Federal Reserve's "QE3" purchases of long-term U.S. Treasury bonds and agency mortgage-backed securities have been running at a net pace of $85 billion a month since September 2012. In May 2013, when the Federal Reserve Board Chairman Ben Bernanke made the open comment about the Fed's intent to start "tapering", the market reacted with a violent jolt as interest rates spike on just his comment. Most economists were surprised when the Federal Open Market Committee decided not to begin tapering the bond purchases following its September policy meeting.

The decision to wait could have been highly influenced to the verbal debate between the President and Congress going on about the budget and debt ceiling that increased the jitters in the market. The market dropped through September and only recovered after the agreement was reached. The partial shutdown of the federal government during the first half of October and a rise in the U.S. unemployment rate to 7.3% in October from 7.2% in September have been among several economic developments keeping the FOMC from making a policy change.

The FOMC next meets on December 17-18, 2013, which is when Ben Bernanke will chair his last meeting and hand the reins over to Yellen in January. It is unlikely he will make a major policy change on his last meeting and allow Yellen to take the role with a clean slate. The next quarterly meeting with any changes and decisions are likely to occur in March, 2014.

The new Chairwoman of the Federal Reserve (as of January 2014), Janet Yellen, and the Board will have to redefine its direction and goals, and how it plans to influence the market to achieve these goals. Janet Yellen is perceived as a Ben Bernanke clone, which is good for stability, but economists are divided on tapering and/or ending the QE3 all together. Given this environment and the leadership transition as Ben Bernanke's term ends, Yellen will likely continue the current stimulus program in January 2014, of buying $85 billion in bonds each month to not make a course change her first act as the new Chairwoman.

The most likely change will be announced during March 2014. At that point, the first quarter influences will be available and the new Board will have had time to reorganize with a redefined direction. Do not rule out the possibility of a QE4. Yellen will want to establish herself and her leadership over the Federal Board and present a strong presentation as to why the tapering must begin, entrenching her actions as the new direction. Many would like to see less government involvement in the markets.

Charles Plosser, President of the Philadelphia Federal Reserve Bank stated on 6 December 2013, "The Federal Reserve should begin to slow down the pace of its $85 billion-a-month asset-purchase program and let the economy stabilize on its own. It would be wise if we began to get rid of this program." Plosser made this statement in an interview on CNBC. "I don't think it is doing very much good for us. I think it has a lot of potential unintended consequences and risks to the economy down the road," he said. Plosser has never supported the Fed's third round of asset purchases. He will gain a vote on the Fed's policy-making committee in 2014. A good way to wind down the program would be to announce a total size of remaining purchases, he said. The Philadelphia Fed President said the November unemployment report was "pretty positive" and showed a "pretty stable positive rate of growth" over the past several months. He forecast the economy would grow at a 3% rate next year.

Some of the effects from QE3 are that most of the money created by the Fed is gathering dust in bank reserves and has not been making its way out to Main Street. Since the Fed launched its latest bond-buying program in September 2012, bank reserves have increased by about $800 billion, whereas the currency circulating in the economy has increased by only $80 billion.

"Asset prices are higher than they should be based on fundamentals. Companies are making profits, but they're not making profits off of higher sales -- they're making profits off of constraining costs and particularly labor," said Catherine Mann, a finance professor at Brandeis University and a former Fed economist. Our analysis concurs as the norm since 2008 when the recover started. Very little growth in America, but companies have reorganized to capture efficiencies and rein in costs. This has limited pay increases to most workers and created a status quo in the business world.

The longer QE continues, the more dramatic stocks could fall once the end of stimulus is in sight. This includes the market as a whole, but more heavily in the financial sector. The effect will cause multiple ripples as it reduces available capital and increases interest rates. When the ripples hit various industries, it will rebound and cause other ripples with new effects on other industries. Banks will feel the effects through less activity in loans, but companies that borrow money to finance other activities will have to adjust to the new economic effects.

Banking One example of the effect is the 6 major banks in America - JPMorgan Chase and Co (NYSE: JPC), Bank of America Corp. (NYSE: BAC), Citigroup Inc. (NYSE: C), Wells Fargo & Co (NYSE: WFC), Goldman Sachs Group, Inc. (NYSE: GS), and Morgan Stanley (NYSE: MS) would be effected by the reduction or stoppage of the bond buying. This would create a change in the flow of money but limit the inflow through the bond purchasing and decrease the holding when providing loans. The rate on interest would go up as the banks need to cover the loss of assets (money) from the Feds. This is not a negative, just the reaction from the action the Fed takes when it will taper or stop the bond buying. What the banks and Fed have to work together on is realizing the affects and managing the changes to limit the effects on the economy.

REITs Financing of loans through many REITs would see a change in the cost of money. Many REITs borrow short term to finance long term loans and with a spike in interest rates, the costs would create one or more negative quarters of cash flow and costs of doing business. REITs are a part of the trillion dollar loan business that cannot be ignored. Banks do not have the capability to handle the flow of money with the current regulations. REITs will react with higher rates on mortgages, more strict standards on borrowing, that will slow many the turnover of money in the markets.

Real estate: The most noticeable impact on Main Street is the real estate market. The Fed's ongoing stimulus efforts for new home buyers with good credit scores have been able to lock in 30-year mortgages at the lowest rates in history. Homeowners with existing mortgages were able to trim their monthly payments by refinancing. Once the Fed decides to slow and then end QE3, rates could quickly shoot up. Such was the situation this summer, when investors thought the central bank was ready to begin tapering its asset purchases in July or September. The average rate on a 30-year mortgage spiked from 3.35% the first week in May, to 4.5% just eight weeks later.

When the Fed decided not to begin tapering in September, interest rates slowly started falling again. The same thing could happen in 2014, and the rise in rates could be even more dramatic, which could put the reins on the housing recovery.

"Eventually the housing market is going to have to fly on its own in an environment of higher interest rates," said Zach Pandl, senior interest rates strategist at Columbia Management. "The Fed would like that process to be very gradual, but we learned earlier this year that they cannot guarantee a gradual rise in interest rates."

Emerging markets: There are global risks as well. Low interest rates in the U.S. had sent investors flocking to emerging markets for higher gains abroad. Continued stimulus could fuel this trend further, but once the Fed starts unwinding the stimulus, investors could find better returns on investments at home and foreign investments drop dramatically.

Ben Bernanke's, the Chairman of the Federal Reserve, statement from the October FOMC meeting, "That rates are likely to stay low for a considerable time after the asset purchases end and perhaps well after the unemployment threshold is crossed". The minutes show Fed officials still expect to reduce their asset-buying in the coming months as a result of improvement in the labor market.

We tend to disagree with this generalization, as the market quickly reacted with higher rates when the Fed publicly mentioned a possible tapering and end to the bond buying, as demonstrated in the Summer of 2013. We would expect rates to spike higher and level in about 30-60 days after the effects in the marketplace are realized.

One move the Fed is considering is cutting the extra interest on reserves banks hold with the Fed, which would drive down already low overnight interest rates even further, probably to just a few basis points, hurting bank profits but adding extra stimulus to the economy. The option that won the most obvious support was a cut in the 25 basis points of interest that the Fed pays to banks on the $2.5 trillion in reserves they have accumulated as a result of its asset buying program. The Fed must consider that by cutting into the banks' income, the banks would look to other areas to increase income. The Fed is a government, non-profit organization, but the banks must continue to turn a profit and will find ways, sometimes not consumer friendly to make profits for their shareholders.

The Fed also discussed the unemployment rate of 7.2% (now 7.3% from November 2013) and maintaining the buying until it reached a low of 6.5%. This is likely to be less of a factor in the decision process, but still on the table for discussion. This also spurred other ideas that could evolve into QE4, which has not taken shape yet.

Another possibility was to expand on the Fed's statement to describe what would trigger a rise in interest rates. It could also say that rates are likely to rise only slowly when they do eventually take off. Our first thoughts are there would be a spike, an over-reaction that would moderate in time as the full effects are analyzed in the market.

We expect a continuation of the bond-buying at the $85 billion a month through March 2014. At the FOMC with Janet Yellon and several new board members, we will see a new direction. Very cryptic language is the norm, but here are concepts we believe they will attempt to follow:

1. Don't do anything to hurt the economy, but attempt to extract from the QE3 bond purchasing program. We are entering mid-term elections and political pressure is high to prevent a sudden down turn in the economy that will affect seats in Congress.

2. Limit the increases in interest rates, as that will have a negatively multiplying effect on the markets and economy. Allowing a slow rise will be acceptable, but any spike of 2% or more will have devastating effects on the flow of money not only in the U.S., but the world economy. The Fed will have to work with the banking industry (that will be a challenge) to find middle ground that allows the banks and the Fed to move forward while limiting the increases in interest rates.

3. The housing market's growth in sales and property value must be continued and prevent home prices from dropping due to increased interest rates. Look for some type of special treatment for home loans that could be funneled through a government program that includes Fannie Mae (NYSE: OTCQB:FNMA) and Freddie Mac (NYSE: OTCQB:FMCC). The Fed has conservatorship control that may be used to enhance home loan rates while other rates rise.

4. Our expected target date for the first reduction in bond purchases is April 2014, after the March FOMC meeting. The economy will be evaluated on the February numbers, but I would expect an initial slight decrease from $85 billion to $70 billion for the next 3 months. That would give the market time to react, and the June FOMC meeting another reevaluation.

Source: The Future Of QE3 And Possible Effects On The Market