QE2 Worked and Stocks Will Soon Show it

by Anthony Mirhaydari | July 5, 2011 4:19 am

The Federal Reserve’s $600 billion “QE2” money printing operation is dead and buried and Chairman Ben Bernanke has taken a “QE3” off the table. The worry in many quarters is that the Fed is beginning to tighten policy as the economy wobbles. As a result, stocks should weaken after a temporary summertime rebound.

This couldn’t be further from the truth.

The biggest achievement of the program is that it killed the risk of deflation and injected some inflationary pressure into the system — enough to unleash the “stealth stimulus” of negative real interest rates. Not only did this avoid a Japanese-style deflationary nightmare, but it maximizes the stimulative effects of monetary easing already in the system.

The QE2 may be over but the Fed is all in. Pedal to the metal. In inflation-adjusted terms, interest rates haven’t been this low on a sustained basis since the mid-1970s. The chart above shows that the  consumer price inflation (red line) is accelerating while the Fed holds short-term interest rates steady (blue line) on a scale that exceeds the run-up to the housing bubble back in 2003 and 2004.

Another way to think of this is to use an analogy. My daughter loves to build little sand dams down on the beach. Imagine such a dam with a pool of water behind it. Before QE2, a little water was seeping out and running back into the sea.

Translation: Although the Fed juiced the monetary base, banks were holding massive excess reserves and money supply growth was anemic. The velocity of money was low because of a lack of demand for loans, stagnating economic growth, and tight credit conditions. This was all deflationary and generally bad.

QE2 was akin to her dumping a bucket of water behind the dam. Suddenly, the added pressure forced more water out. This weakens the integrity of the dam. More water flows out. The dam weakens even more.

Translation: QE2 forced inflation expectations higher via commodity price inflation and a weakened dollar. This pushed real interest rates deeper into negative territory. And now, new loans are essentially subsidized. Banks are loath to hold cash in their vaults at near zero interest rates while inflation picks up. This is forcing the velocity of money to increase as the reservoir of money (the monetary base and bank reserves) spills into the sea (money supply) with ever greater force.

So people are worried about the end of QE2. They shouldn’t be.

Returning to our analogy: While no more water is being added, the dam has already started to crumble.  All the pent up monetary policy stimulus that has accumulated since the Fed made its first rate cut four years ago is about to be unleashed. It’s a dynamic that hasn’t yet been seen in this bull market.

And while it will ultimately be very inflationary, and could even fuel the next asset bubble, the dynamic practically ensures that the economy and the stock market will keep growing in the months to come.

For investors, the most basic yet most important advice is to avoid cash and fixed income like the Black Death in this environment. As long as inflation stays below 4% or so, stocks will be the place to be. Precious metals are under pressure because the end of QE2 is seen as a dollar positive. So avoid gold and silver for now.

At the sector level, it’s all about cyclicals. Financials and semiconductors look appealing and can be played with the Financials SPDR (NYSE: XLF[1]) and the Semiconductor Holders (NYSE: SMH[2]). As for individual holdings I like Marshall & Ilsley (NYSE: MI[3]) and Kulicke and Soffa (NASDAQ: KLIC[4]).

Be sure to check out Anthony’s new investment advisory service, The Edge. A two-week free trial has been extended to InvestorPlace readers. Click the link above to sign up.

The author can be contacted at anthony@edgeletter.com[5]. Feel free to comment below.

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