The Independent Investor: The End of QE II: Wax On, Wax Off

"Wax on, right hand. Wax off, left hand. Wax on, wax off. Breathe in through nose, out the mouth. Wax on, wax off. Don't forget to breathe, very important." — Mr. Miyagi, from "The Karate Kid"

Miles of newsprint and thousands of terabytes of Internet space has been devoted to what happens Friday, the day after the end of the Federal Reserve Bank's quantitative easing experiment. Some say it bodes ill for bond and stock prices. Others argue it will have little or no impact. I say it is simply the end of one program and the beginning of another.

The total cost of the Fed's Treasury bond purchase program amounted to $600 billion. The goal of QE II was to put more money in the hands of consumers and corporations (especially small businesses) in an effort to boost spending and hiring. Unfortunately, it did little to jump start the economy in either area.

In a circular exercise similar to Mr. Miyagi's admonition to "wax on, wax off" the Fed purchased the bonds from the banks, hoping that they would in turn lend that sudden windfall of money to us. But instead, these banks just bought back more treasury bonds. The banks simply refused to lend that money and the Fed has no authority to make them.

QE II did result in lowering interest rates to historical lows, however, which allowed financial speculators to borrow money cheaply and to invest that cash (really short-term speculative trading) into commodities, stocks and all sorts of higher yielding securities. Those of us who have retirement savings also benefited somewhat as the stock market rose and we regained some of the losses incurred in 2008-2009.

All it meant for the average Joe was higher gas and food prices as commodities skyrocketed into the world’s latest financial bubble. That actually slowed spending. As for corporations, the big guys already had more cash on their books than they needed. Their profits were exploding as well and none of them felt the urge to hire more labor since they were doing just fine with what they have now. And why not, since their workers have had no wage increases in years, have had their benefits cut to the bone, and if they complained, well, there are always 13.9 million unemployed American who would be happy to take their job at an even lower pay rate ... As for small business, QE II was a total bust for them.

Doomsayers, such as Bill Gross, the highly respected portfolio manager of the world's largest bond house, Pimco, believe that without the Fed’s support, interest rates in the Treasury market will spike, the economy will fall back into recession, and the stock market will tank in response. A host of knowledgeable players subscribe to that theory and have made their views known to anyone who will listen.

Others believe that there are still plenty of potential investors, especially overseas, who will still want to own U.S. Treasury bonds as a safe haven and as a dependable source of income. Interest rates might rise a little, especially on long term bonds (10-20-30 years) but the rise would depend on the growth rate of the economy and inflation expectations. The stock market would no longer be underpinned by the easy money policy of QEII but that might actually be a good thing since it would reduce the amount of speculation that seems to be a massive part of today’s stock markets.

Of course, the caveat here is that Washington politicians come to their senses and do not allow the country to default by refusing to raise the debt ceiling.

In my opinion, I do not think that the Federal Reserve has taken us this far only to cast us adrift to the whims of fate. The Federal Reserve will continue to keep its role as the largest buyer of Treasuries. A week ago, for example, the Fed stated that it intends to use the proceeds of maturing debt that it already owns to buy more treasury bonds as needed. A total of $112.1 billion will mature within the next 12 months. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of Fannie Mae and Freddie Mac bonds,  which will also mature. That will mean an additonal$10 billion to $16 billion of cash maturing every month. When you add it all up, the Fed has another $300 billion in cash, more than enough to maintain its support of the bond market.

Remember too that the Fed isn't about to give up on the economy just because QE II didn't quite do the job that they intended. Like Daniel in The Karate Kid, the Fed has learned some valuable lessons from their latest experiment.

I predict that they will try again, as early as next month, to come up with yet another way to stimulate the economy. I’m not sure what they have up their sleeves, but I expect we will start hearing rumors about a new plan very shortly. That will certainly play well in the stock market, don’t you think?

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.