What Every Investor Should Know About the End of QE

Equity markets around the world yesterday expressed their distaste for the possible end of the Federal Reserve's quantitative easing (QE) policy.

Share prices tumbled from New York to Tokyo. Even resource-rich Australia and emerging markets, including China, saw shares decline following the release of the minutes of last month's Federal Open Market Committee meeting.

What upset the markets was a discussion at the January FOMC meeting about when and, more importantly, how to end the current QE policy.

As someone put it on Bloomberg Radio yesterday, "Would the markets have been happier if the FOMC was ignoring the issue of how to end QE?"

To understand how ending the QE policy might affect the economy and markets, investors need to understand how QE operates.

Here's How QE Works

The Fed creates credit ("prints" money - the Fed doesn't actually print money, but creates credit electronically), which it then uses to purchase Treasury notes and mortgage-backed securities from its member banks through the Federal Reserve Trading Desk. Treasury notes and mortgage-backed securities wind up on the Fed's balance sheet while the money created by the Fed ends up on the banks' balance sheets.

What impact does this have on the economy?

First, by purchasing large amounts of long-term Treasury notes and mortgage-backed securities, the Fed pushes long-term interest rates lower. We can see this by the record low mortgage rates that are beginning to pull the housing market out of its doldrums. You can thank the Fed for that.

Second, the cash that banks realize from the sale of their Treasury notes and mortgage-backed securities to the Fed should, in theory, get loaned out to individuals and businesses to fund investments and accelerate economic activity.

Unfortunately, even though banks are flush with cash and despite evidence that banks are easing their lending standards somewhat, loan growth is slowing.

Bankers argue that there isn't enough demand for loans from creditworthy borrowers. Potential borrowers argue that the banks will not lend to them.

The real issue is that interest rates are so low that banks cannot be adequately compensated for taking the risk of lending money. The higher the interest rate a bank can charge on a loan, the looser its definition of "creditworthy" will be - up to a point. No one is creditworthy if inflation is out of control.

Banks are more willing to lend to homebuyers because the loan is backed by a hard asset -
the property being mortgaged.

But making a loan against business receivables or making an unsecured loan is another story. When there is such a small return on capital, lenders are more concerned about the return of capital.

So much of the money so thoughtfully supplied by the Fed through QE sits on bank balance sheets as excess reserves held at the Fed. The money never goes anywhere and, except for holding down long-term interest rates and bolstering the housing market through low mortgage rates, has a minimal impact on the overall economy.

Whatever Happens to QE, ZIRP Remains

The FOMC meeting discussions last month centered on how to end QE by reducing or ending asset purchases. Several proposals were entertained, including adopting a flexible approach to asset purchases depending upon the latest economic data or to hold the Treasury notes and mortgage-backed securities already purchased for a longer period of time.

For investors, the key point is that if the Fed stops or even just slows its purchase of Treasury notes and mortgage-backed securities from its member banks, long-term interest rates will rise.

But because the Fed has already said it intends to keep short-term interest rates (Fed funds) at zero (zero-interest-rate policy or ZIRP), short-term rates should remain unchanged. This is called steepening the yield curve.

For investors thinking about buying or refinancing a home, the end of QE will certainly mean higher mortgage rates.

Investors who own long-term bonds or bond funds will see capital losses as bond prices decline. Money market funds, which rely on short-term instruments, are not likely to be affected.

There are a few ways for investors to take advantage of higher long-term interest rates, including ProShares Short 20+ Year Treasury ETF (NYSE: TBF), which goes up when long-term U.S. Treasury notes go down in price (up in yield).

The ProShares Ultra Short 20+ Year Treasury ETF (NYSE: TBT) is a leveraged ETF that aims for twice the return of TBF. Direxion Daily 20+ Year Treasury Bear 3x Shares (NYSE: TMV) seeks three times the inverse return on the NYSE 20+ Year Treasury Bond Index.

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