QE3 Is You and Me: How Investors Can Replace the Fed

Includes: IVV, SPY, TBT, TLT
by: Michael A. Gayed, CFA

I'll never forget seeing headline after headline in the first two months of 2011, focused on this overwhelming bearishness toward bonds and how advisors were positioning for a substantial increase in interest rates. I looked in amazement, wondering how so many people could think they could all be right at the same time.

The Fed seems to have made it relatively clear that Quantitative Easing 3 (QE3) is not in the cards right now, and that its bond purchase program would end in June on schedule. Now remember, the whole purpose of QE2 was to lower bond rates. That certainly did not happen – interest rates ROSE during the Fed's purchase program. If anything, the real QE2 happened before the Fed began its program by investors anticipating the move.

So what happens now? I spoke with a good friend and well informed investor this past weekend and he coined the term “QE3 is You and Me.” I'm almost tempted to write a jingle about it. We do not need the Fed to initiative QE3 to lower rates – rather we are likely to cause it to happen once again. What leads me to this conclusion is the still overwhelming bearishness in bonds. One way of knowing this is based on the assets under management in the UltraShort Bond ETF (NYSEARCA:TBT), which far exceeds daily trading volume, implying that there is a lot of sticky money in the trade.

But more than that, take a look at what the relative price ratio of long bonds (NYSEARCA:TLT) is doing against the S&P 500 (NYSEARCA:IVV). As a reminder, a rising price ratio means the numerator/TLT is outperforming (up more/down less) the denominator/IVV.

(Click chart to expand)

Notice that the ratio peaked in mid-August 2010, right before the massive equity bull run we've all experienced. That ratio increased substantially as rates declined to historic lows in 2010, which is visible by the sharp rise in the price ratio (a rising price on TLT means lower rates). Notice also that the ratio bottomed this February, despite what appears to be otherwise strong equity markets. The ratio continues to be making higher lows, and recent price action does seem to suggest a continued trend higher.

Should outperformance continue, it would be because either equities drop much further, rates decline, or some combination of both. I suspect the herd will replace the Fed in the bond market this time around.

Disclosure: Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.