“We don’t know when quantitative easing will end, but it’ll likely end badly.”
The preceding isn’t an actual quote but an amalgam of opinions recently expressed by a number of well-known Wall Street types about the ultimate outcome of the Federal Reserve’s unprecedented monetary stimulus programs of the past four-plus years. Folks ranging from hedge fund manager Stanley Druckenmiller to commodities guru Jim Rogers and CNBC personality Jim Cramer are warning that the Fed’s expansive asset-buying program (roughly $3 trillion and counting) is creating a bubble that’ll eventually burst and create a big financial mess.
Others aren’t so sure. Either way, most observers agree that Fed Chairman Ben Bernanke’s monetary manhandling has put the U.S. economy in unchartered territory and has investors peering into the unknown.
The Fed has kept the federal funds target rate close to 0% since late 2008, with promises to keep it at historically low levels until the unemployment rate falls to 6.5% and as long as inflation remains under 2.5%. Then came three rounds of quantitative easing where the Fed has printed money to buy large amounts of assets from the market––mainly mortgage-backed securities and longer-term Treasurys––to boost their prices and reduce their interest rates to help prime the economic pump through increased lending and liquidity.
During the current third round of QE, the Fed each month is buying $85 billion in mortgage securities and Treasurys, though it says it could taper those purchases going forward depending on economic conditions.
The questions concerning what will happen in the post-QE world are many: How far and how fast will interest rates rise when the central bank boosts the federal funds rate and stops acting as the bond market’s sugar daddy? Will equities take a breather––or worse––without the Fed pushing investors into risk assets? When will the Fed stop buying assets?
“The Fed won’t start reducing its purchases until the economy shows signs of expansion because it doesn’t want to derail the recovery,” says Jennifer Vail, head of fixed-income research for U.S. Bank Wealth Management. Some Fed officials have hinted it might start curtailing purchases later this year, but disappointing March employment numbers put that time frame in doubt.
One of the biggest questions of the QE era is how will the Fed divest of these holdings. “I’d find it hard to believe the Fed is confident it’ll be able to completely unwind a $3 trillion balance sheet,” Vail says. “It’s hard to say I’m confident about something I’ve never seen in my lifetime, let alone been able to read about in books.”
Wealth managers and investment strategists alike are trying to figure out how to play ball in a game where the playbook, to some degree, is being rewritten on the fly. “Everyone is trying to gauge the risks and unintended consequences of when these programs are going to stop,” says Mark Balasa, co-CEO and chief investment officer at Balasa Dinverno Foltz LLC, a wealth management firm in Itasca, Ill.
Abyss Or Opportunity?
Proponents of QE say the Fed has done a masterful job of keeping the economy afloat and inflation in check. Critics of the Fed’s program––and they are legion––say QE has lost its effectiveness. To keep printing money and purchasing assets, they say, unnecessarily pumps more liquidity into the economy, which perpetuates a misallocation of resources and sets the stage for currency devaluation and hefty inflation.