How end of Fed QE2 will affect stock market

In just a couple months, the US Federal Reserve’s second quantitative-easing campaign will wind down. This program has been highly controversial since its birth, so the Fed is under tremendous pressure not to launch a third round of QE. And if QE2 indeed ends on schedule this quarter, it has major implications for the US stock markets.

Central banks around the globe are notorious for trying to cloak their actions. One of many ways they obscure their activities is by coining new phrases to name them rather than using classic historical terms. Quantitative easing is a pleasant-sounding euphemism for the dangerous practice of debt monetization. The Fed is creating massive amounts of new money out of thin air to buy bonds.

When normal investors buy bonds like US Treasuries, they have to first sell something else to raise the cash to make the purchase. The money supply doesn’t change at all. But when the Fed buys bonds, it finances its purchases by conjuring up new dollars that never existed before. This new fiat currency is pure inflation, an increase in the money supply that is injected into the economy the moment the bond issuer spends it.

The goal of converting debt into new money is simple, to manipulate financial markets. The Fed doesn’t even try to hide it, Chairman Ben Bernanke and the rest of the Fed leadership openly discuss this mission. By buying bonds with newly-created fiat money, the Fed is actively trying to drive down interest rates by increasing bond demand.

Remember how bonds work from Finance 101? When they are first issued, they have a contractually-set yield. For example, a bond might originally cost $1000 and pay 6% interest annually over its lifetime. But after this bond is first bought from the issuer, it can be sold in the secondary marketplace. The higher the demand for it, the higher its price is bid. Even if it gets up to $2000, it still only pays 6% on its original $1000 face value. Thus its effective yield for a new buyer has fallen to 3%. Buying bonds drives their prices up and yields down.

Bond prices and effective yields move inversely. So the higher Fed buying pushes up bond prices, the lower their yields fall. And when our central bank is using the currency it creates to buy our own government’s sovereign debt, this price-yield dynamic drives down all interest rates. US Treasuries, considered “risk-free” since the US government can print infinite new dollars to ensure it never technically defaults, form the foundation from which all other interest rates are set.

Conspiracy theorists endlessly rant and rave about many markets, but hypocritically ignore this biggest and most-blatant market manipulation of all. By monetizing US Treasuries, the Fed is actively manipulating almost all interest rates in our entire economy. As in all manipulation schemes, this causes great distortions and misallocations of resources. Just one example is robbing savers blind. Thanks to Bernanke’s Fed, we’re not earning a fair return on our hard-earned capital. Why should the Fed steal from savers to subsidize debtors?

The Fed embarked on this unprecedented Treasury monetization, which it happily calls quantitative easing, for a couple key reasons. The Fed only directly controls a couple interest rates, the federal-funds rate and the discount rate. The former is what private banks are paid to lend money through the Fed to other private banks, while the latter is what private banks are charged for borrowing directly from the Fed itself. The problem is both of these rates are very short-term, usually just overnight in duration.

Manipulating overnight rates usually does little for the long end of the yield curve, interest rates for debt maturing over years or decades such as car and house loans. But monetizing Treasuries enables the Fed to directly manipulate long rates, forcing down borrowing costs (and savings income) in the entire economy. On top of this, the Fed had already driven its own short rates to zero when it originally started quantitative easing.

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