QE2 Will Spur Demand for More Risk

Next week, the Federal Reserve is expected to announce another round of Quantitative Easing, or as the cool kids are calling it, QE2. All investors need to understand that QE2 will have a major impact on their investments. The most important aspect is that Quantitative Easing will help fuel a demand for riskier asset classes.

More specifically, Quantitative Easing will aid a shift toward growth stocks at the expense of bonds and value stocks. QE2 won’t affect the direction of stock market—that will remain strong—as much as it will alter the market’s internal leadership.

Now let me back up and explain this in more detail. Over the last several weeks, the Federal Reserve has made its QE intentions crystal clear. I’m surprised that they haven’t taken out a full-page ad in the Wall Street Journal.

The Fed’s main problem is that the economy is still grinding its wheels, as today’s GDP report shows, and interest rates are already at 0%. As a result, the central bank now plans to inject money into the economy by buying enormous amounts of U.S. Treasuries.

The only question now is “how much?” The general consensus on the Street is that QE2 will clock in around $500 billion, although some say it could be as much as $1 trillion. We’re really in unchartered territory here.

Personally, I think the plan will be less than the Street expects. Remember, the C in FOMC is for “committee” and that means compromises. We can expect uber-hawk Thomas Hoenig, the president of the Kansas City Fed, to be a “nay” vote, and he may be joined by one or two others. I expect an announcement of around $250 billion give or take, which may even cause a near-term pullback. Much like a pampered Hollywood starlet, Wall Street just loves to be disappointed when it receives favors.

So where will Bernanke and his buddies get all this cash? That’s easy. They have a magical super power where they can write checks out of thin air. Or, at least, they can create currency out of thin air. The U.S. dollar has already gotten smacked around in the currency pits lately, although it’s not nearly as bad as the dollar’s haters make it sound.

My thesis that the Fed’s purchasing of debt will lead an exodus out of Treasuries and into riskier assets may sound counterintuitive. The important point is that the market is already heavily tilted toward low-risk assets. Currently, there’s a lot of money—too much money—sitting on the sidelines. Moody’s Investors Service reports that U.S. companies are sitting on $943 billion in cash. Three companies; Cisco (CSCO), Microsoft (MSFT) and Google (GOOG) account for the largest portion. Hey, who needs the Fed? They could do a QE all by themselves!

The simple fact is, to paraphrase Jimmy McMillan, bonds are too damn high. In fact, the move out of bonds has already started. Yesterday, the yield on the 30-year Treasury closed at its highest level in nearly three months and it’s now over 50 basis points from its low point in late August. Not by coincidence, that was right when the stock market bottomed. In short, the stock rally has been at the expense of bonds.

What this means is that at long last, investors are finally choosing sanity over liquidity. Let’s look at some numbers: Since August 31, the S&P 500 is up 12.8%. That’s a nice run, but the growth side of the index as measured by the S&P 500 Growth Stock Index is up 19.3%. That’s nearly double the 10.4% gain for the S&P Value Index.

Here’s the key to understanding QE2’s impact: Don’t think of it as a stock movement. Instead, think of it as a risk movement with a seal of approval from the Federal Reserve.

Posted by on October 29th, 2010 at 10:19 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.