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Quantitative What? Protecting Your Portfolio against QE2

Jargon is a time-tested trick to blind average investors. What does "Quantitative Easing" mean to you? Nothing? That's the way Washington wants it.

How about QE2? Still no?

Hint: QE2 is not an ocean liner. But in terms of economic impact it is every bit as big, and it is headed your way. In fact, every American has already been affected, even if most of us are unaware. The U.S. dollar is plunging and QE2 is to blame.

Quantitative What? Protecting Your Portfolio against QE2

In the simplest terms possible, "quantitative easing" is all about printing money. Of course, creating money out of thin air undermines the value of the dollar.

In August, the Federal Reserve announced that it would begin a new round of quantitative easing or "QE". How much money would be poured into America's financial system was left uncertain. Estimates ranged from $100 billion to a high of $2 trillion.

The first shock wave from this announcement was the uncertainty created around the dollar. Its decline so far exceeds 6 percent. But the effects of QE2 shock waves reach much further – right into your portfolio.

A Simple Explanation of QE2

Jargon can be simple. It's a wonder that anybody successfully hides behind it.

Quantitative easing (or QE) was used once before, during the worst of the financial crisis. Federal Reserve Chairman Ben Bernanke says that the first round quantitative easing aided the economy by buying $1.75 trillion of mortgage debt and Treasuries from August 2008 through March 2010. That was QE1.

QE2 will work much the same way. The Federal Reserve will buy up billions or trillions worth of government bonds from bondholders such as major banks.

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The Fed will pay slightly more than the market rate for U.S. government debt notes. The bank (in this example) will enjoy greater liquidity and will supposedly be eager to lend its newfound money. That in turn should stimulate the economy.

But where will the money come from? In effect the government will print it. By generating money in this circular way, Washington also dilutes the currency. Again, that's why the dollar has been in freefall since Bernanke's announcement.

Why not try more traditional tools to get the economy moving? Cutting interest rates is one of the usual tricks. But the catch is that Fed interest rates are already near zero. They can't be reduced any further.

The other familiar tool is economic stimulus. By spending gobs of money on infrastructure and other federal works, the government could create jobs and kick-start the economy. But U.S. debt levels have reached nosebleed territory. There is no political will to incur more debt before the U.S. election.

That leaves only one option. QE2.

What It Means To You

When the dollar goes down, most everything we buy goes up. Keep in mind that the dollar is the world's reserve currency. Most commodities are priced in dollars.

Gold is the most obvious example. As the dollar plunges, gold moves in exactly the opposite direction.

Quantitative What? Protecting Your Portfolio against QE2

Most global commodities will rise in sync with the dollar's decline. But the world doesn't know yet how much money the Fed will print. That means no one can be sure how much more the dollar will decline, and how much higher commodity prices will rise.

Stocks will also tend to rise in as the dollar sinks. This is not a sign of a real increase in value. It is simple inflation in the valuation of tangible assets vs. paper money.

Presumably some foreign stocks will perform better than U.S. equities. That's because their income and assets may be denominated in currencies which are rising against the dollar.

It has been possible to make money in anticipation of QE2, which is set to launch in November. Recent joblessness reports suggest that QE2 will come in on the high side of estimates. Growth is unexpectedly sluggish. Unemployment is stubbornly high.

But, there is a danger in creating asset bubbles.

If QE2 fails to make a real difference to the economy, investors will eventually lose faith. Stock valuations are built in anticipation of future earnings. If the economy stagnates and future corporate earnings disappoint, share prices could eventually implode.

It's also important to note that the de facto devaluation of the greenback has created alarm overseas. Monetary authorities are warning about a looming currency war. I'll have more about the implications of that in future postings.

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