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The Fed’s Third Time Won’t Be the Charm

By Benjamin Shepherd on September 14, 2012

On Thursday, the Federal Reserve announced that it will implement a third round of quantitative easing, colloquially referred to as QE3. This time around, the Fed will buy $40 billion per month in mortgage-backed bonds and will attempt to hold interest rates at their current levels at least through mid-2015.

Considering that the Fed is already holding about $2 trillion in bonds on its balance sheet, one can’t help but wonder how much good QE3 is actually going to do. Fed Chairman Ben Bernanke himself doesn’t even seem entirely sold on the idea. In his press conference yesterday, he said that creative monetary policy won’t solve everything that ails the economy, and that policymakers (i.e., Congress) need to pursue steps of their own on the fiscal front. But apparently, Bernanke, like most Americans, doesn’t have much faith in our current batch of legislators and isn’t expecting much action until after the elections.

In deciding to focus on mortgage bonds yet again, the Fed is clearly trying to keep rates down to put some spring in the real estate market’s step. But with the 30-year mortgage rate currently sitting at 3.55 percent for well-qualified borrowers, mortgage rates probably can’t go much lower.

With QE3, Bernanke is essentially pushing on a string; you can’t even give away nearly free money if no one really wants it.

At this point, the issue isn’t borrowing costs. Rather, it’s the lack of demand for such borrowing, in large part due to the persistence of high unemployment and continued consumer deleveraging. Additionally, prospective mortgage borrowers must have pristine credit histories and be able to produce sizable down payments, which is a pretty tall order at the moment.

So QE3 is likely to amount to a stimulus measure for the rest of the world. If past experience is any guide, most banks and financial institutions will end up deploying this surfeit of liquidity by chasing investment opportunities overseas.

During QE2, a large percentage of the money the Fed created flowed into emerging markets, such as China, or into commodities, which created new mini-bubbles. Many investors have been wondering why the Chinese central bank has failed to provide more stimulus itself, as its own economy has been flagging. The most likely answer is that they saw QE3 coming and have been waiting to see what happens this time around. If the program has its intended effect on the US economy, that’s great for the Chinese. If it fails to prime the US economy, but much of the money created flows into China, that’s okay too. Either way, China gets at least some benefit without cost to themselves.

As usual, the ball is now in the politicians’ court, and we aren’t likely to see much play until after the elections. In fact, there probably won’t be much movement at all until the newly elected legislators take office in January, since the lame duck Congress isn’t likely to get much done. If congressmen on both sides of the aisle wouldn’t play nice a year ago, they’ll have no incentive to do so now.

Although the market is pleased by more easing, QE3 isn’t likely to do much for the real economy. Just ask the Japanese.

So how do we play QE3?

On the domestic front, mortgage-backed securities are the obvious beneficiaries.

On Thursday’s news, the usually stolid Vanguard Mortgage-Backed Securities ETF (NSDQ: VMBS) moved up by 0.3 percent, which is actually a fairly big one-day move for the fund, as it gained 17 cents. Most of its action is usually measured in basis points, and its trading range over the trailing month was just 29 cents.

On a more global scale, we should look for moves in commodities, particularly oil and gold, and the emerging markets, particularly China.

That will make physical gold funds such as iShares Gold Trust (NYSE: IAU) and even Market Vectors Gold Miners ETF (NYSE: GDX) attractive as hedges against potential inflation. Both funds made sizable moves in the wake of previous rounds of QE.

For Chinese exposure, consider iShares FTSE China 25 Index Fund (NYSE FXI). China has been a laggard so far this year, but they’ll likely realize more benefit from QE3 than we will, so look for some movement there.

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