On Wall Street, riding the Federal Reserve’s coattails is one of the oldest tricks in the book. And making investment decisions in lockstep with the Fed has resulted in profitable results – especially over the past 2 ½ years. This has cemented the Fed’s mystique along with memorable axioms like “Don’t fight the Fed!”
Up until now, not fighting the Fed has worked like a charm but will it continue working into the indefinite future? How will the end of QE2 impact your portfolio? And what comes next?
Born out of Crisis
The Federal Reserve System is the central banking system created in 1913 in response to the financial panic of 1907. Its principal duties are to maintain stability within the financial system, to supervise and regulate banks, to conduct the nation’s monetary policy and to provide financial services to depository institutions and the U.S. government.
The Federal Reserve System’s structure is comprised of the presidentially appointed Board of Governors (or Federal Reserve Board), the Federal Open Market Committee (FOMC), twelve regional Federal Reserve Banks located in major cities throughout the nation, numerous privately owned U.S. member banks and various advisory councils.
Contrary to what many people think, the Federal Reserve is actually a private bank and not a federal agency. It receives no appropriated funds from Congress. Why is that important? Because it means the Fed, like any corporation, can be forced into dissolution or outright bankruptcy due to poor decisions.
The current Fed is actually the third central banking experiment in the U.S. Its predecessors were the First Bank of the United States (1791-1811) and Second Bank of the United States (1816-1836).
The Fed: A Considerably Different Institution
If the Fed’s main job is to help others during times of financial crisis, it’s perfectly reasonable to expect that it itself should be in top notch financially fit condition.
Before the onset of economic recession, the Fed held between $700-800 billion in U.S. Treasuries on its balance sheet. In late 2008, it started buying $600 billion in toxic mortgage-backed securities. By the spring of 2009, it held approximately $1.75 trillion in bank debt, sub-prime mortgage debt and other securities. As of June 15, 2011 the Fed’s balance sheet ballooned to $2.869 trillion but with just $53.04 billion in capital. Is that enough firepower to head off another major crisis?
By absorbing trillions in toxic mortgage debt, the Fed has taken on liabilities much larger than any financial institution or banking corporation could possibly handle. But in doing so, it has also put its own financial situation at great risk. Today, the Fed has 54-to-1 leverage ratio which easily exceeds Bear Stearns and Lehman Brothers just before their failure. Is today’s Fed in a stronger or weaker financial position versus five years ago?
Experimenting with Q’s
After injecting an experimental drug into a specimen, a scientist must wait for its reaction. If the reaction is poor, the scientist should not repeat the same procedure or something similar hoping for a better result, but move on to something else.
In this regard, the Fed began its first round of experimenting (QE1) with a multi-billion dollar buying spree of toxic assets. It subsequently followed that up with a second round of experimenting (QE2) – this time buying U.S. Treasuries. How did the specimen react?
The price of stocks as measured by the SPDR DJ Wilshire Total Market ETF (NYSE:TMW) and government bonds as measured by the iShares Barclays 20+ Yr Treasury Bond ETF (NYSE: TLT) responded by rising. And so did riskier assets – junk bonds, measured by the SPDR Lehman High Yield Bond ETF (NYSE:JNK); highly leveraged real estate investment trusts REITs in the Vanguard REIT ETF (NYSE: VNQ) and mortgage REITs in the iShares FTSE NAREIT Mortgage ETF Fund (NYSE:REM). Although each of these areas responded favorably to the Fed’s experimenting, the treatment ultimately failed to reach its intended patient – the broader economy.
What will a Post-QE2 World look like?
The Federal Reserve’s laboratory experiments on the U.S. economy have had mixed results. While asset prices have run ahead, the real economy is stalling.
Intervening in the financial system has never been a problem for the Fed and the past several years have shown it. But their exit strategy carries lots of unknown risks and unanswered questions.
Now that the Fed’s QE2 experiment is set to end on June 30, what will it mean for your investments? Should investors be ‘fighting the Fed’ or going along with them? ETFguide’s next Webinar titled “What’s Your Post QE2 Strategy?” will tell you.
Market forces greater than the Federal Reserve are already forming and they will affect the future direction of securities prices.
This article is brought to you by ETFguide.com. ETFguide is the information leader on exchange-traded funds because of its vendor-neutral approach and its progressive reporting style. Unique features include an ETF bookstore, a monthly e-mail newsletter, and subscription based ETF portfolios.
