With the U.S. Federal Reserve's third quantitative easing cycle drawing to a close over the next few months, it is worthwhile to explore the expected impact across asset classes once this program finally ends. By far more than any others, two major asset classes have been grossly misperceived throughout the post crisis period regarding how they are likely to fare without the steady torrent of liquidity from the Fed. For while stocks are likely to face a more challenging new reality, both U.S. Treasuries and gold may not just survive, but actually thrive once QE3 draws to a close.
It has been a steady mantra over the last several years. It is the notion that once the U.S. Federal Reserve ends its daily bond purchases that the U.S. Treasury market is in for a heap of trouble. The conclusion here is that the only reason Treasury yields are so low is because of Fed bond purchases, and the moment they stop buying a gaping void of demand will emerge that will force yields markedly higher. Perhaps this will be the final outcome for the Treasuries, but virtually no evidence exists from recent historical experience to support the idea that this is how the market will react.
In fact, the exact opposite has been true throughout the post crisis period. When the Fed has been actively engaged in daily U.S. Treasury purchases as part of one of its QE programs, Treasuries (NYSEARCA:TLT) have suffered notably with yields steadily rising. This outcome is particularly ironic given that one of the primary stated intents of these asset purchase programs over the years has been to lower Treasury yields.
Conversely, during periods when the Fed has discontinued its daily Treasury purchases, the Treasury market has rallied strongly with yields dropping markedly.
But how can this be? How is it that when the Fed is buying billions of dollars worth of Treasuries that yields are rising? And how is it when the Fed stops buying billions of dollars worth of Treasuries that yields are falling? The answer is simple. The Fed is not and has never been the only buyer of Treasuries in the market place. For when the Fed is engaged in bond purchases, it is encouraging all other market participants to take on more risk, which leads to the net decline in demand for Treasuries as many investors that are not known as the Fed opt instead for stocks (NYSEARCA:SPY) and spread product like high yield bonds (NYSEARCA:HYG). As for when the Fed stops buying Treasuries, the reality that economic and market fundamentals do not support many of these higher risk asset classes at elevated valuations coupled with the fact that the end of free money flow from the Fed leads to a reduced demand for these same higher risk assets causes many investors to assume a more defensive posture in their portfolios. Where do they go? To the relative safety of U.S. Treasuries, which has resulted in a net increase in demand despite the loss of Fed purchases.
Whether this same outcome takes place following the end of QE3 remains to be seen. But given that the long anticipated sustained economic recovery continues to fail to materialize, one should not be too surprised if the relative safety of U.S. Treasuries continues to grow in appeal in the coming months. This may help explain at least in part why U.S. Treasuries are off to such a good start in 2014.
The story for gold has been similar throughout the post crisis period. The common perception has long been that gold (NYSEARCA:GLD) has been rising as a direct result of the Fed's QE programs. And unlike Treasuries, gold at one time demonstrated the ability to perform well during periods when the Fed was actively engaged in asset purchases. This was true for gold, of course, until QE3.
But this does not tell the whole story, for unlike stocks, gold also has demonstrated the ability to perform well even during periods when the Fed has stepped away from daily liquidity injections.
So how can this possibly be? Isn't gold the direct beneficiary of the currency debasement that results from global central banks aggressively printing money into circulation? And wouldn't periods of prudence by global central banks when they stop the printing presses take the wind out of the sails of the gold trade? The answer here is once again fairly straightforward. While currency debasement and protecting against the risk of future inflation is certainly an argument for purchasing gold, it is not the only reason. If it were, gold would have performed dramatically better since the beginning of 2013 when the Fed launched into their latest and arguably most aggressive stimulus program in QE3. Instead, it is also influenced by factors such as perceived general price stability (benefiting not only from the threat of inflation, but also deflation), the threat of geopolitical conflict, the strength of the U.S. dollar relative to global currencies (which helps explain in part why gold has performed so well since the early 2000s when the U.S. adopted a weak dollar policy) and the potential for financial market turmoil. Moreover, it is an asset class that is heavily subject to sentiment as well as management from a select group of major financial institutions that have a notably large influence on the overall gold market. Lastly, it is also worth noting that gold is an asset that is being widely used as collateral for loans in places like China, which introduces and entirely different element of risk into the equation.
With all of this in mind, the possibility exists that the positive effects on the gold market of any geopolitical and/or economic stability that might occur once the Fed ends its bond purchases may more than outweigh the negative effects on gold from no further currency debasement. Such is the consideration for the gold investor as QE3 draws to a close.
While QE3 is gradually winding down to its end in the coming months, it does not necessarily mean that the Treasury and gold market are going to suffer along with this loss of liquidity flow. History during the post crisis period has shown that these asset classes can thrive without the crutch of daily asset purchases from the Fed. And time will tell if they can repeat this performance the next time around.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met. I am long TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I am also long Treasuries via the IEF. I am long stocks via the SPLV and XLU as well as selected individual stocks. I also hold a meaningful allocation to cash at the present time.