End of QE2 is upon us, no wonder markets are down

Posted on 05 June 2011 with 1 comment from readers

Last summer financial markets looked decidedly queasy until the Fed announced its QE2 program to keep interest rates low by buying up its own bond issues. It did not actually start until November but the magic recovery in markets from correction mode began as soon as it was announced in August.

Can the Ben Bernanke Fed produce a similar rabbit out of the hat this year? And do we have to take the pain before August again? It is no wonder stocks are feeling a bit sick right now, quite apart from the lousy economic fundamentals that show the economic recovery to have been largely waffle from Wall Street.

QE3

It is of course harder to make a case for QE3 while we are so clearly beginning to suffer from the inflation created by QE2. The Fed is still in a state of denial over this but where else can inflation be coming from with the economy so weak?

But with a money printer at the Fed you do have to wonder if this might not be a repeat of last year.

Veteran UK banker Lord Rothschild warned last week that the world economy seemed in a bad way with the eurozone debt crisis, Japan’s earthquake and nuclear meltdowns and the US deficit at $1.5 trillion and debts close to 100 per cent of GDP.

In the US the worry is that we have reached a tipping point that will be different from last year. Rolling over debts can only go on so long before they become unsustainable and a systemic danger.

If bond markets were to conclude that this is the case, and the Fed has stopped its bond buying program then it is going to be a matter of look out below for bonds and much higher interest rates. That will not be good for stocks or real estate either.

Debtor nations

Piling more debt upon debt is only ever a temporary solution, for individuals as well as nations. Even devaluation is impossible if all countries take similar measures, against what do you devalue?

Real assets in the form of a narrow range of commodities – essentially precious metals and energy – seems to be the answer, although some like Lord Rothschild are beginning to ask if this asset class is not also due for a correction.

Defensive diversification is the only investment approach that makes much sense right now.