QE3: Unlimited Purchases With Limited Benefits

Includes: GLD, SLV, SPY
by: Disruptive Investor

The highly anticipated QE3 was finally announced by the Federal Reserve, and the immediate reaction of asset markets has been positive.

This article presents a summary of QE3, along with a discussion of its impact on the economic scenario and asset classes.

QE3 In Brief

According to the FOMC release, the QE3 would encapsulate the following:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee's holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

Further, keeping interest rates artificially low beyond 2014 forms another part of QE3:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Timeline For QE3

There is no definite timeline set by the Federal Reserve for QE3. The purchases of agency mortgage-backed securities and asset purchases will continue until there is substantial improvement in the job market. According to the FOMC statement (linked above):

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

Therefore, just like keeping interest rates at near-zero levels for an extended period, the QE3 program will remain in play for an extended period with the level of asset purchases varying in line with changes in economic activity.

Benefits Of QE3

The FOMC has stated that it will continue the program to extend the average maturity of its holdings of securities as announced in June 2012. Further, the reinvestment of agency debt and agency mortgage-backed securities in agency mortgage-backed securities has also been assured.

Both these commitments are focused on keeping longer-term interest rates at lower levels and preventing any strain in the financial markets.

Keeping long-term yields at suppressed levels would minimize interest outflow, and also support the policy of financial repression as discussed in one of my earlier articles.

My Opinion Of QE3

I had written in one of my earlier articles that the Fed can afford to delay QE3 with economic activity still showing no signs of a collapse. However, the recent jobs report did squeeze the Fed on QE3. Therefore, the outcome was largely expected and discounted by the markets.

With respect to the labor markets, I see no potential benefit for the labor markets from QE3. The program is designed to bring further relief to financial markets.

However, QE3 does not provide any policy trigger, which would boost job growth.There might be limited indirect benefits. However, they will not be enough to bring about a substantial decline in the unemployment rate.

On the contrary, deciding to keep interest rates artificially low until mid-2015 suggests that policymakers are increasingly sure that sluggish economic growth and job market will remain.

QE3 might also bring forward renewed fears of high inflation, which in my opinion, is very likely in the next 3-5 years.

The Central Banks balance sheet has already swelled to USD2.8 trillion, and the current program would extend the balance sheet well beyond USD3 trillion over the next 3-6 months.

The immediate fear of inflation is reflected in the 10-year Treasury bond yields, which have trended higher to 1.8%. Gold has also surged by nearly 2% as I write this article. A weakening dollar has also loaned support to oil, which is trading higher.

If interest rates do remain low until 2015, I see higher commodity prices leading to inflation for households. This might be negative in a weak job market scenario.

Therefore, QE3 exuberance might not last very long as market participants realize that it might not do much for the real economy.

Investment Suggestions After QE3

As mentioned above, I am of the opinion that the excitement related to QE3 might not last very long.

Equity markets have largely discounted QE3, and market participants will be disappointed when they realize that QE3 hardly does any good to the real economy.

In line with this, I will avoid fresh exposure to equities. I personally expect markets to correct by 10-15% over the next few months. If this correction does come, buying into the index would be a good idea.

For index investing, I would look at the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), which generally corresponds to the price and yield performance of the S&P 500 Index.

I remain very bullish on precious metals for the long-term. With interest rates expected to remain near zero until 2015, precious metals will continue to provide superior returns.

I would consider exposure to gold and silver at these levels and on further correction. Physical gold and silver would always be a preferable option. However, investors can also consider exposure through the gold or silver ETF. The SPDR Gold Trust ETF (NYSEARCA:GLD) and the iShares Silver Trust ETF (NYSEARCA:SLV) would be good investment options.

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.

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