QE3 is on Its Way - Here's How to Prepare

Federal Reserve Chairman Ben Bernanke spoke to the U.S. Senate Tuesday and yesterday (Wednesday) in his two-day biannual meeting with Congress - and failed to make any promise to institute more stimulus measures.

He did leave the door open for the Fed to do something - even if it won't commit to what that will be.

The markets rallied, although investors were disappointed that the Fed chief couldn't deliver a bigger commitment.

But make no mistake - quantitative easing, or QE3, is coming.

That is assured for one simple reason.

The U.S. government can find few buyers for its debt at current low interest rates. And as Bernanke has stated publicly, low interest rates will remain in place until at least 2014.

That means the Fed will have to continue its role of financing the budget deficit of the U.S. government through the inflation of its balance sheet.

Life Way Before QE3

It was not always this way.

At one time, Americans bought the Treasury bonds that made up the national debt. But when Ronald Reagan took office in 1981, his economic goals of cutting taxes and raising defense spending guaranteed that massive budget deficits for the government's domestic capital formations could never have financed the $200 billion-plus deficits.

That's when foreign investors, primarily the Japanese, began to buy U.S. Treasury debt.

Eventually Chinese buyers joined the Japanese in scooping up U.S. debt securities. However, due to the impact of The Great Recession, foreign investors pulled back from buying U.S. Treasury bonds.

As a result, the Federal Reserve, under Ben Bernanke, had to undertake massive measures to save and recapitalize both the United States and the global financial system. Since not enough buyers could be found for all the trillions in Treasuries, the Federal Reserve inflated its balance sheet through a bookkeeping mechanism to underwrite the budget deficit of the U.S. government.

As a result of this, the balance sheet of the Federal Reserve expanded from around $700 billion in 2007 to about $3 trillion today. And the work of the Federal Reserve is nowhere close to being done.

Federal Reserve to Announce QE3 in August?

Quantitative easing 2, which consisted of the Federal Reserve purchasing about $700 billion in Treasury securities from November 2010 through June 2011, was announced by Bernanke in a speech at Jackson Hole, WY in the summer of 2010.

Get ready for QE3 to be introduced when Bernanke again strides to the podium at Jackson Hole in late August.

To prepare for this, investors should expect the PowerShares U.S. Dollar Index (NYSE: UUP) and iShares Barclays 20+ Years Treasuries (NYSE: TLT) to fall. The Eurozone debt crisis has buttressed the value of the greenback as a safe haven asset. But that will not last forever. It was only last August that Standard & Poor's downgraded the United States for the first time in history.

Over the period of QE2, the UUP fell about 20%, from over $25 to the low $20s. Over the same period, the TLT dropped to the low $90s from about $110.

And while history may not repeat itself, it can rhyme.

In concert with the falling U.S. dollar and Treasuries when QE3 is announced, gold and silver should rise.

SPDR Gold Trust (NYSE: GLD) soared from under $120.00 to over $180 during the period of QE2. During the same time, the exchange-traded fund for silver, iShares Silver Trust (NYSE: SLV), rose from under $20 a share to more than $40 a share. The exchange-traded fund for oil, United States Oil Fund (NYSE: USO) also surged as investors fled the U.S. dollar for hard assets such as gold, silver and crude.

QE3 could also mark the time to get back into the Chinese market.

Over the course of QE2, the exchange-traded fund for China, iShares FTSE China 25 Index (NYSE: FXI), rose about 20% from about $40 to over $48 a share. It is now trading around $33.50. Growth is slowing in China, but Beijing is taking measures to stimulate the economy.

This provides one of the main factors for shorting the U.S. government after QE3, and going long the Chinese government.

The $3 trillion on the Federal Reserve's balance sheet eventually will become a huge liability for the U.S. economy. Investors will have to be found to buy these securities.

So far it is not happening, which is why Operation Twist, selling short-term securities to buy those with longer terms, has been extended.

At present, China has about $3 trillion in foreign currency assets. These were booked by China selling more goods than were imported.

This $3 trillion was earned by China. As a result, it is a tremendous asset for the country.

Legendary investor Jim Rogers once said that a weak currency is a sign of a weak economy, which is a sign of a weak government. Like QE2, QE3 will weaken the U.S. dollar and Treasury bonds, as did QE2.

That does not bode well for the U.S. economy.

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