Quantitative Bubble Blowing?

Includes: DIA, QQQ, SPY
by: Investment Pancake

Quantitative easing is back on track. Yesterday, the Federal Reserve announced that it will continue to print dollars and deploy them into mortgage backed securities, agency debt and U.S. Treasuries. The goal is to add liquidity to the system, hopefully pressing banks into making loans, and inspiring people to do things with all that printed liquidity - like invest in risky assets, or purchase goods and services.

Many have indicated that quantitative easing may lead to higher inflation, or a severe currency devaluation. Another concern, though, is whether quantitative easing creates "artificial" demand for those assets the Federal Reserve has pledged it will continue to add to its balance sheet. After all, it is not likely that the Federal Reserve will be a lasting presence in the markets for this debt, but merely a temporary buyer. When the Federal Reserve does exit the market for mortgage backed securities, agency debt, and Treasuries, the overall demand for this lower risk asset group will drop - that is, unless other players besides the Federal Reserve step in to take the Federal Reserve's place as a buyer. A reasonable enough bet, but when you boil it down, it simply comes down to betting on the future arrival of a greater fool to buy assets as the Federal Reserve sells them. Markets built on the expectation of a greater fool tend to fare poorly over the long term, as owners of internet stocks from 2000 will attest.

Fine, you say, if you are an equity investor, or someone who does not own many U.S. Treasuries. But consider that there may be a spill over impact on higher risk assets. With the price of Treasuries "artificially" low thanks to quantitative easing, some investors are forced to seek alternatives to low risk assets, and purchase equities, or speculative grade debt. To that extent, the price of higher risk assets must also reflect an "artificial" risk premium fueled, indirectly, by quantitative easing. If the Federal Reserve is fueling a demand bubble in mortgage backed, agency and Treasury debt, it is doing so in the equities markets (and other risky asset markets) as well.

At the moment, the markets are greeting the Fed's announcement with enthusiasm. Indeed, the last round of quantitative easing accompanied a dramatic increase in equities prices - perhaps the same will hold true this time. That, at least, appears to be the market's expectations today. Investors should be open to the possibility, though, that the market's expectations may well change for the worse. After all, isn't it fair to assume that there may be fewer fools out there today than there were before the financial crisis of 2008 burned generations of investors? For the sake of the Federal Reserve, let's hope investors, as a group, have not learned better.

Disclosure: No positions