Have Preferred Stock Investors Already Moved Beyond QE?

Sep. 30, 2013 7:00 AM ETPFF46 Comments

There is a certain amount of evidence suggesting that concerns about the Federal Reserve backing out of its $85 billion per month Quantitative Easing (QE) bond-buying program have already been "priced in" by preferred stock investors.

Ignoring the possibility of QE "tapering," high quality preferred stock market prices have been relatively stable for almost two months now. In fact, their average market price has returned to pre-QE2 levels closing on Friday, September 27, 2013 at $24.34 (source: CDx3 Notification Service database, www.PreferredStockInvesting.com).

And the share price of the iShares S&P U.S. Preferred Stock ETF (PFF) is now ignoring the threat of tapering as well, increasing consistently since August 19.

Consequently, the average annual current yield of high quality preferred stocks is now at 7 percent, equal to their long-term average.

"High quality" preferred stocks are defined here as those that have a variety of risk-lowering characteristics such as having cumulative dividends and investment grade ratings (Preferred Stock Investing, Fifth Edition, page 132).

September Fed meeting - no price reaction

While high quality preferred stock prices edged slightly lower in the days prior to September's Fed meeting (see Preferred Stock Yields Edging up In Advance Of Fed Meeting), the drop was nothing like what we saw in June or early-August.

In advance of the Fed's September 17-18 meeting, Fed representatives were hinting very strongly that QE tapering was going to begin, and yet the selling of preferred stock shares that surrounded the prior meetings did not materialize.

Have preferred stock investors already "priced in" a tapering of the Fed's QE program or, unlike pretty much every investor in the world, did preferred stock investors correctly guess in advance that the Fed was not going to take any action in September (despite repeated suggestions to the contrary)?

QE here to stay?

Or are preferred stock investors just starting to doubt that the Fed will ever back out of QE in any meaningful way?

I know it sounds odd, but there is an increasing amount of speculation asserting that it will be quite some time (if ever) before the Fed is able to gracefully back out of its Quantitative Easing bond-buying program.

It's an interesting idea and one that may at least partially explain why preferred stock market prices did not fall in any significant way in advance of September's Fed meeting as they had previously - even when the Fed announced in advance that tapering was likely to be on the September agenda.

Inflation - Where is it?

The basic argument for a somewhat permanent QE existence is that there is no real reason to stop the program. Classic economic thinking says that inflation will surely be the result of the QE program. And I get that line of thinking - increasing the money supply lowers the value of that money so it takes more dollars to buy the same thing (aka inflation).

But here's the problem: The classic economic model fails to explain what has actually been happening in the real world. After four years of the Fed's QE program, there is no inflation.

And others have seen the same result. The UK has been running a QE program for some time now and guess what - no inflation there, either. And the granddaddy of all QE programs? Japan has had their QE program in place for thirteen years now and the inflation predicted by the classic model is nowhere to be found.

If Quantitative Easing by a central bank causes inflation, where is it?

While I understand and agree with the idea that buying $85 billion per month in bonds has to have a significant downside, we will apparently have to look somewhere other than inflation to find it (starting with the income devastation it has levied on savers).

QE offset by increased bank reserves

One explanation of why the U.S. QE program has not produced the expected inflation is that a significant chunk of the new cash is being sequestered in the form of increased bank reserves. After all, the new domestic (Wall Street Reform Act) and international (Basel III) reserve requirements kicked in at just about the same time as the Fed's QE2 (2010).

Putting all of that new cash in the hands of consumers (in the form of increased loans) would certainly drive prices up, but requiring banks to keep it in the vault as increased reserves, not so much.

But that explanation only goes so far. At $85 billion per month, the volume of QE bond-buying far exceeds the increase in bank reserves that we have seen over the last three years.

Tapering already "priced in"

If QE tapering is going to trigger a preferred stock selloff, why didn't it in early-September when Fed representatives had announced in multiple public forums that they were likely to start doing so at their September meeting?

When combined with the fact that high quality preferred stock yields have returned to their long-term QE-free 7 percent average and prices have returned to their pre-QE2 levels, it could be argued that the effects of tapering have already been "priced in" by preferred stock investors.

If that's the case, whatever selloff of high quality preferred stocks was going to happen has already happened.

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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Securities identified within this article are for illustration purposes only and are not to be taken as recommendations.

This article was written by

Whether you are the kind of investor who sticks with preferred stocks with a CDx3 Compliance Score rated 10 out of 10, or whether your portfolio has room for 9-score-and-lower securities, stay tuned for future articles recapping new IPOs and interesting preferred stock activity that we notice here at the CDx3 Notification Service.

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