Kevin Fusco, The Daily Record Newswire
A few weeks ago, the Federal Reserve delivered to investors what had been rumored and debated for months in the form of a fresh round of quantitative easing, now affectionately labeled QE3.
While the announcement did not come as a surprise to many, the underlying details and open-ended framework sent some investors running to certain asset classes and away from others. Now that the novelty of QE3 has worn off, and investors have had time to digest the breadth of the stimulus package, which investments stand to benefit the most, and which others might be worth the risk?
Having long ago exhausted the option of lowering the Federal Funds Target Rate to control money supply, and thus stimulate growth, QE3 aims to bolster the economy by putting downward pressure on long-term interest rates by increasing the purchase of long-term debt securities.
The Fed will further act to bolster the sluggish U.S. economy by continuing “Operation Twist” as well. Under Operation Twist, the Fed will sell shorter-term debt while it purchases the aforementioned long-term securities. Thus, the questions that beg to be asked are: What will the Fed be buying, and what will it be selling?
On the buy side, the Fed will look exclusively at mortgage backed securities (MBS), with purchases of roughly $40 billion per month. According to Bloomberg, the Fed’s
MBS purchases will total roughly half of all new MBS issued each month.
This should lead to more expensive valuations, and support the entire MBS asset class. It may prove hard for individual investors to access these new issuances, thus a mutual fund or exchange traded fund in the MBS asset class should provide sufficient exposure, with some relative protection hopefully provided by the portfolio’s diversification and professional management.
We have already begun to witness the effect of QE3 on the MBS market, as the average yield advantage to Treasurys (often referred to as the “spread”) contracted to a record low.
As yields on MBS fell, and their prices rose, the advantage of taking on more relative risk for a higher coupon rate evaporated, sending investors to other areas in the fixed income marketplace to find income. While there may still be room for price appreciation in mortgage backed securities, better yields are more likely in investment-grade and high-yield corporate bonds.
On the sell side, it would be too easy to assume that Treasurys would carry the most risk with the onset of QE3 and continuation of Operation Twist. Shorter duration bonds should, logically, be under the most pressure as the Fed sheds these positions in favor of longer-term options.
While this effect was true right after the announcement, it has since dissipated. Yields on the 10-year U.S. Treasury note surged to more than 1.8 percent in the wake of QE3’s arrival, but have since fallen back below pre-announcement levels.
While the upward move was certainly related to QE3, the subsequent drop may be more appropriately attributed to inflation fears, as well as the looming “fiscal cliff” concerns. This seesaw pattern may continue into the short- and intermediate-term, as these two forces jockey for attention.
The same can also be said for the equity markets, as the initial relief rally has quickly given way to more sideways trading. While the longer term impact of QE3 on the equity markets may be positive, there are many shorter-term concerns that will overshadow the benefits in the interim. The impending presidential election, ever-changing conditions in Europe, economic concerns in China, and the fiscal cliff will steal the spotlight from QE3 over the short-term.
Keep in mind though that, as of now, QE3 has no end date. The MBS purchases will continue for as long as the Fed sees them as necessary to fulfill its dual mandate: control inflation and ensure full employment. The latter of these two may ensure some form of quantitative easing for the foreseeable future.
Investors are left to weigh the risks of higher yielding, but relatively lower quality, fixed-income investments, or exposure to equity markets in which short-term volatility could likely eclipse QE3 benefits. Under such circumstances, reliance on investment basics is prudent.
An objective-based asset allocation framework that diversifies investments among numerous asset classes and sectors, while no guarantee to protect against loss, should help to reduce volatility and allow investors to also target areas that stand to benefit in the unprecedented times created by an ultra-low interest rate environment.
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Kevin Fusco is senior vice president of Fusco Financial Associates Inc. of Towson. He can be reached at 410-296-5400, extension 109, or Kevin.Fusco@LPL.com.
