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The markets have become so fixated on the Federal Reserve's quantitative easing (QE2) policy that they seem to exclude most everything else. It has become consensus that the Fed will ride to the rescue and be successful in its efforts to stimulate the economy back to a more sure-footed path. That is absolutely possible like almost anything. However, how much attention has the market paid to the possibility that it does not work?

As many investors know, consensus is the great enemy. History has shown that consensus leads to complacency and complacency leads to too much capital chasing the same theme. So it is important to ask ourselves "What if QEII Backfired?"

So far, commodities and stocks in general have been big winners of the QEII policy announcement. The exceptions or losers have been bonds and most bank stocks. The early impact from QEII has been an increased investor appetite for risk assets (equities) and an abandonment of the U.S. dollar. The result has been a stunning increase in commodity prices.

Click to enlarge:
Bond Bandwagon

(Data Source: StockCharts.com)

So while the Fed is busy trying to fight deflation, consumers around the world are probably starting to think "Mission Accomplished". As the accompanying chart shows, since Bernanke first hinted at QEII at a speech in Jackson Hole Wyoming in late August, gasoline and oil futures are up almost 20% - not to mention food prices such as coffee and wheat prices.

To be sure, not all of the increase in global food prices is the fault of the Fed's policies. Weather patterns around the world have combined to put a dent in supply of most agricultural products and a resulting pinch on consumer wallets. So the Fed is at least partially off the hook for the rise in global food prices. Be that as it may, consumers are likely going to see the price of the leading brands of breakfast cereal going up; Kraft Foods (KFT) has announced price increases on about 40% of its product lines, and bacon prices have risen 16% since September according to U.S. government data.

The rise in food prices is not limited to the U.S. China has reported increases in food prices of close to 10% in recent months. At worst, it helps to throw a wrench into the Chinese government's plans to cool inflation in the country and wrestle the excesses in the economy to the ground. India is also experiencing likewise inflation pressures.

Russia, Brazil, India, China and other Asian nations have also been worried that the impact of excess U.S. dollars being unleashed by the Fed will end up in the form of capital inflows into their respective countries. As hot money flows in, it tends to result in the increase of asset prices such as stocks and real estate.

Many of these countries still maintain fresh memories of the last time they had hot money come and go. The result was substantial damage to their respective economies and currencies that were left in tatters. Thus, they are keeping a wary eye on the policies of the U.S. Fed and their potential to cause collateral damage.

If food and energy prices stay strong enough for long enough, they would threaten to seep into the inflation outlook for the broader economy - thereby lifting interest rates for all loans including mortgages. If this happens, a good part of the Fed's intended goals could be relegated to the scrap heap as a result of the unintended consequences of its actions.

Disclosure: No positions

Disclaimer: This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance. Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.


Source: Are Markets Discounting What Happens if QEII Doesn't Work?