Federal Reserve – How to Tame the Monster it Created

Thanks to quantitative easing (QE) stocks are up 130% and more. The Fed created a monster of a rally, but how do you tame the monster without killing it? As the most recent Fed minutes indicated, it may be ‘easier’ than some think.

Never under estimate the psychological power of a dangling carrot. For years the Federal Reserve used the promise of more QE as an incentive (carrot) to drive stocks higher.

This has worked well. Too well. The Dow Jones, Russell 2000 and other major indexes are trading at all time highs and the Fed’s next challenge is to tame the monster (rally) it created without killing it.

How can this be done? Perhaps with the ‘reverse dangling carrot approach.’ Before we talk about the reverse carrot approach, let’s review how the ‘dangling carrot approach’ works.

The ‘Dangling Carrot Approach’

At how many post FOMC meeting conferences did we hear Ben Bernanke assure Wall Street that the Federal Reserve is ready and willing to assist?

From July – November 2010 Bernanke’s steady assurance was nearly as potent as QE2. Do you remember the August 2010 Jackson Hole summit? Bernanke then said: “I believe that additional purchases of longer-term securities … would be effective in further easing financial conditions.”

The placebo QE effect was strong enough to lift the S&P 18% before QE2 became official on November 2, 2011. Thereafter the S&P 500 rallied another 16% to the April 2011 high. QE2 ended in June 2011.

From October 2011 – September 2012 the Fed did nothing more than dangle the QE3 hopium carrot and the S&P 500 rallied 36%. QE3 was finally announced in September 2012, followed by “QE4” (replacement of Operation Twist by outright Treasury purchases).

Containing The Fed Monster – The ‘Reverse Dangling Carrot Approach’

From 2009 – 2012 the Fed talked up QE and stocks. Today the S&P 500 trades 135% above its 2009 low and the Fed knows it created a monster (rally). The Fed also knows that everyone else knows this is a phony funny money rally.

How can the Fed contain the monster it created – take away the punchbowl without causing a severe hangover. The ‘reverse dangling carrot approach’ is born.

Dropping hints about more QE contained the bear market, so dropping hints about reducing QE should tame the QE bull market. This process may have already begun.

The release of the Fed minutes on February 20, showed dissention among committee members about the duration and scope of QE.

Whether this division over the issue is real or just a new PR strategy to contain the Fed monster, I do not know. But we do know that stocks sold off right after the Fed minutes were released.

Just like controlled fires can stimulate a forest, the Fed may try to light ‘controlled burns’ to manage the stock market. As in nature, the summer time (starting in May) is a good time for a ‘controlled burn’ on Wall Street. Shareholders should plan accordingly.

I personally view the Fed like an unwelcome guest. Some guests bring happiness wherever they go. Some (like the Fed), whenever they go. Unfortunately, the Fed’s comment about leaving (scaling back QE) appear to be only a tease.

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Glaring but Misunderstood QE – How Much the Fed is Really Spending

QE1, QE2, QE3, expiring Operation Twist, and now QE4. Which of those programs are “sterilized” (non-inflationary) and which ones devalue the dollar? If you’ve lost track, here’s a quick visual summary.

Will Operation Twist be replaced by outright QE was a question addressed here early in December. As it turns out, the Fed decided to do just that.

We now have multiple layers of QE working simultaneously. What’s the total amount being spent and will inflation finally take off?

QE Tally

There are three official tranches of quantitative easing (QE):

1) QE3, announced on September 13, 2012. The Federal Reserve will buy $40 billion per month worth of mortgage-backed securities.

2) QE4, announced on December 12, 2012. The Federal Reserve will buy $45 billion per month worth of longer term Treasuries (corresponding ETF: iShares Barclays 20+ Treasury ETFTLT).

QE4 will be replacing Operation Twist in 2013. Operation Twist is considered “sterilized” or cash neutral QE. Operation Twist simply reshuffled the balanced sheet (sell shorter term in favor of longer term maturities). It did not expand the balance sheet.

Unlike Operation Twist, QE4 will be financed by “non-sterilized” or freshly printed money. This process increases the Federal Reserve’s balance sheet and the amount of money in circulation.

3) Reinvestment of maturing securities. In a December 12 press release, the Federal Reserve stated: “The Committee is maintaining its existing policy of reinvesting principal payments from its holdings mortgage-backed securities and, in January, will resume rolling over maturing Treasury at auction.” This amounts to roughly $25 billion/month of sterilized QE.

In total, the Federal Reserve will buy $110 billion worth of Treasuries and mortgage-backed securities every month until the unemployment rate drops below 6.5% and inflation remains below 2.5%.

The first chart below illustrates QE3, QE4, and reinvestments separately and how the three layers combined compare with QE1 and QE2.

The second chart provides a more detailed glimpse of the Fed’s balance sheet (and a mere glimpse is all mere mortals are allowed).

The Fed’s balance sheet as of November 21, 2012 stood at $2.84 trillion and is expected to balloon another $1 trillion over the next 12 months.

Currently $966 billion or 34% are invested in agency debt, mainly mortgage-backed securities. In other words, one of every three dollars in circulation is backed by toxic assets, the same stuff that caused the “Great Recession.”

Inflation

Inflation, where art thou? The Fed’s balance sheet exploded from below $1 trillion to nearly $3 trillion, but inflation (let alone hyper inflation) has been a no show.

Will the current round of QE deliver on inflationist’s predictions? I doubt it.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

Operation Twist about to Expire – Will it be Replaced by Outright QE?

The Federal Reserve’s $45 billion a month Operation Twist program is scheduled to expire at the end of this month. Based on the sound bites of several Reserve presidents, there will be a replacement. Will it be more outright QE?

Operation Twist is circling the drain, set to expire on December 31, 2012.

Will Operation Twist be extended or even be replaced by outright QE?

What’s the difference between Operation Twist and Quantitative Easing (QE)?

Operation Twist Basics

Since September 2011, the Federal Reserve has been buying about $45 billion of longer-term Treasuries per month with the proceeds from sales of a like amount of shorter-term debt.

Unlike outright QE purchases, the Operation Twist asset reshuffle does not add to the Fed’s balance sheet.

Will Operation Twist be Replaced by Outright QE?

Boston Federal Reserve Bank president Eric Rosengren, one of the most vocal proponents of Fed asset purchases, advocates to continue spending $45 billion a month buying long-term Treasuries.

St. Lois Federal Reserve Bank president James Bullard has a different opinion. He said that the expiring Operation Twist program should not be replaced on a dollar-for-dollar bases, because asset purchases that expand the balance sheet (like QE) have a bigger effect than Twist.

QE Tally

So far the Federal Reserve has purchased about $2.4 trillion worth of government bonds and mortgage-backed securities.

During QE1, the Fed spent about $78 billion a month.

During QE2, the Fed spent about $75 billion a month.

During QE3, the Fed is spending about $40 billion a month.

Concurrent to QE2 and QE3 the Fed is reinvesting the proceeds of maturing securities. Based on a balance sheet of $2.4 trillion, this is a significant amount.
Abount $25 billion a month.

For the month of December, the Fed will spend about $65 billion buying Treasuries and mortgage-backed securities. This is “new” money.

An additional $45 billion of the proceeds from selling short-term Treasuries is re-invested in long-term Treasuries.

QE’s Effect on Treasury Prices

What does all of this artificial demand for long-term Treasuries mean for Treasury prices and corresponding ETFs like the iShares Barclays 20+ year Treasury Bond ETF (TLT)? It appears that the effect of QE3 on Treasury prices has been muted. It certainly hasn’t driven prices up as should be expected.

In fact, 30-year Treasury prices have been stuck in a trading range capped by two long-term resistance lines and buoyed by an 18-month support line. As long as prices remain in that range the stalemate is likely to continue.

With strong seasonality for stocks straight ahead (and an inverse correlation between stocks and long-term Treasuries), I assume that price will break down.

Simon Maierhofer shares his market analysis and points out high probability, low risk buy/sell recommendations via the Profit Radar Report. Click here for a free trial to Simon’s Profit Radar Report.

Can QE Bail Out the Stock Market Once Again?

Stocks faltered during QE1 and recovered. Stocks also tumbled during QE2 and rallied back to new recovery highs. From its September high the S&P 500 has already lost 100 points, will QE3 bail out the stock market again?

QE3 looks like the Fed’s biggest boomerang yet. Bernanke announced QE3 on September 13. The S&P closed at 1,460 on this faithful day and recorded a new multi-year recovery high the very next day (1,474.51). Since then the S&P 500 is down 6%, the Nasdaq-100 nearly 10%, and Apple about 23%.

Can QE3 bail out stocks once again?

Based on the QE track record the answer is a plain and simple: Yes.

However, this may not be the time to take a plain vanilla approach. QE3 is the same animal as QE2, but a different breed and even QE2 had some serious genetic flaws that showed up on stock charts as big gashes.

QE2 vs. QE3 – Same Animal, Different Breed

Back in November 2010, I wrote an article on the correlation between the Fed’s Permanent Open Market Purchases (POMO, also known as QE2) and the S&P 500.

Specific transactions, such as coupon purchases of $3.5 billion or larger (back then the Fed was buying Treasuries), resulted in positive S&P performance 89% of the time (when there were no POMO buys, the S&P was up 58% of the time).

Via QE2 the Federal Reserve bought an average of $75 billion worth of Treasuries a month. Via QE3 the Federal Reserve is buying $40 billion of mortgage-backed securities (MBS) per month.

In Addition, throughout November, the Federal Reserve will purchase $47 billion worth of long-term Treasuries (maturities from 2018 – 2042) and sell $37 billion worth of shorter-term Treasuries (maturities from 2013 – 2015).

The net amount of securities purchased by the Federal Reserve (in November and December) will be $50 billion, compared to about $75 billion during QE2 (I’m not sure if the Fed is still reinvesting maturing Treasuries and if it will extend Operation Twist, scheduled to expire at the end of the year).

QE2 – Not Everything That Shines is Gold

The thought of QE2 triggers images of relentlessly rising stock indexes. Sandwiched in between those “market on steroids” segments, however, were nasty selloffs. One in March 2011 (Japan earthquake) and one in May 2011 (the May 2010 and July 2011 meltdowns happened right after QE1 and QE2 ended).

From the beginning to the end of QE2 the S&P gained only 11%. The chart below shows exactly when the various QE’s started, when they ended, how much stocks gained, and the selloffs in between.

QE doesn’t guarantee higher prices, but thus far in this QE bull market stocks have always been able to recover from any decline and move on to bigger and better highs. Will this be the case again?

Technical Indicators

The S&P 500 and Dow Jones didn’t show any major breadth divergences at their September highs and there are some giant open chart gaps, which suggests that prices will indeed end up recovering some of the recent losses.

So the odds for an eventual year-end rally are good (not sure if it will reach new recovery highs), but we haven’t seen panic selling or bullish price/RSI divergences that would point to any sort of more permanent bottom (we may say a daily price/RSI divergence at today’s close).

At the Profit Radar Report we will simply continue to adjust the stop-loss level for our short positions. This virtually guarantees a profitable trade and exposes us to all the profit potential on the short side. We will take profits once indictors tell us a bottom is near.

The Profit Radar Report monitors money flow, seasonality, sentiment, technicals and other developments to identify low risk and high probability trades and investment opportunities for subscribers.

VIDEO: Will QE3 Drive Treasury Bonds to New All-Time Highs?

Now that QE3 is here we have to talk about the elephant in the room; Treasury bond yields and Treasury bond prices. The purpose of QE3 and Operation Twist is to lower yields. Will it work and is there an investment opportunity?

The Federal Reserve is buying Treasury bonds (more via Operation Twist than QE3). According to the law of supply and demand this should result in higher T-bond prices and lower yields.

This video looks at the historic effect QE and Operation Twist had on 30-year Treasury prices (cause and effect) and identifies the next high probability trade set ups.

ETFs that track long-term Treasuries are the iShares Barclays 20+ year Treasury ETF (TLT) and its double inverse cousin, the UltraShort 20+ year Treasury ProShares (TBT).

Continuous analysis of long-term Treasuries is provided via the Profit Radar Report.

>> Click here to watch video on Treasury bonds.