How To Profit From Quantitative Easing

by: David Cretcher

In a recent Bloomberg article, St. Louis Federal Reserve President James Bullard expressed his opinion that with inflation stable the Fed would continue buying bonds.."I think it's going to be a while on the QE program," he said. Bullard a voting member on the policy-making board further addressed the inflation issue "We've got a lot of room to maneuver here."

If he is right and the Fed continues buying, the question for investors, love QE or hate it, is how can one make money from Quantitative Easing?

The great federal bond buyback

The simple way for investors to view Quantitative Easing is as a bond buyback program. When the Fed engages in QE in it buys US Government Bonds on the open market. This takes government bonds out of the economy and adds currency into the system. It seems there is a lot of focus on the additional currency side, but less focus on the shortage of bonds.

In a rough way QE is a little like a stock buyback. Stock buybacks reduce the number of shares in circulation and hopefully push the price of the remaining shares up. QE reduces the number of bonds in the market pushing the prices of the remaining bonds up and therefore, interest rates down.

Here is a graph of the Feds Treasury bond purchasing:


And here is a graph of their mortgage bond purchases:

These are not just charts of how many bonds have been purchased. They are also graphs of how many fewer bonds are available to buy on the open market.

QE until when?.

How long Quantitative Easing continues is anyone's guess, but according to the article, the Fed has stated it will continue to keep the interest rates to near zero until unemployment was below 6.5 percent. Bullard projected that the economy may hit that number in the middle of 2014.

It is unlikely in the next year the Fed will stop buying bonds. It is also unlikely even with employment below 6.5 percent that it will stop then if we still have and output gap. An output gap is where the actual GDP is below potential GDP.

If the sequestration slows economic growth in the coming months as many believe, it may further expand the output gap..

If that is the case, then we can expect the Fed to continue its 85 billion dollar per month bond buying or possibly even increase it.

Too many dollars chasing too few bonds.

There is too much talk of monetary inflation and too little talk of bond price inflation. This buyback will cause bond price inflation as too many dollars chasing too few bonds.

For the investor, the simple result of QE is there are fewer US Government Bonds in circulation, because the Fed has bought many of them. The Fed is in a sense cornering the Government Bond market. This is a dynamic the investor can act on to act on.

Sequestration may also mean there will be fewer new bonds issued. This could add to the shortage, although this dynamic is more complicated since it also affects bond demand..

This ongoing bond shortage will mean bond prices will go up or at least have a very difficult time going down in price.

Investment strategy

If you believe there will be more Quantitative Easing or less government spending in the future consider for part of your portfolio direct treasury bond investments or investments in ETFs like (NASDAQ:TLT), (NASDAQ:VGLT), or for the more aggressive (NYSEARCA:EDV) and government mortgage bonds like (NASDAQ:MBB), (NASDAQ:VMBS), and (GNM)..

But pay attention to the unemployment rate and the Fed communications for signs the Fed has change its mind. But even if the Fed begins to unwind the bond purchases it is a large balance sheet an the positions are too large to unwind rapidly.

With high unemployment and the economy running below potential I think a change of course will be unlikely, but as always keep a weather-eye.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.