Will This Be the “QE2” That Sinks?

The “QE2” was launched two weeks ago. But it is not the legendary ocean liner “Queen Elizabeth 2” returning to active service. QE2 is the second wave of quantitative easing (QE) that the Fed has introduced by purchasing U.S. Treasuries.

Billions of additional dollars will be created out of thin air to pay for the purchases of U.S. T-bills. In the short term, the buying has pumped more air into the bubble already formed in U.S. Treasuries and other bonds. In the long term, the QE2 can be expected to depress the U.S. dollar further and to revive inflation. This will eventually lead to the higher yields demanded by bond buyers, bringing the bond bull market to its end.

The start of the secular bond market dates back to 1981, when the U.S. bond yields peaked at 16.7% for T-Bills, 15.7% for 10-year Treasuries and 17.3% for corporate grade bonds. In the course of the subsequent 30 years, the combination of declining inflation and the Fed using cuts in interest rates to revive the cyclical downturns in the economy has brought all yields to historically extremely low levels.

In those 30 years, with every recession, the Fed drove its benchmark federal funds rate to lower and lower levels.  Finally, the Fed has run out of room to lower short-term rates.  In December 2008, in a desperate attempt to halt the financial and economic meltdown, the Fed cut the federal fund rate to the current zero to 0.25% rate. That has left the Fed little choice but to implement QE1. Commencing March 2009, it purchased $1.0 trillion in long-term bonds.

The QE1 has done wonders for the bond and stock markets and has helped stabilize the financial industry and the economy. Alas, 18 months later, the U.S. and global economy are showing renewed recessionary signs, jolting the Fed into another round of QE. Most of the bond classes have responded by soaring to new highs. However, the response has been subdued in stocks, suggesting the quantitative easing of the Fed will provide only modest benefits to the economy.

Public investors, who have remained wary of stock investments during the entire 2009 stock market rebound, responded to the probability of a recessionary double-dip by funneling even more money into long-term bonds. The National Association of Institute of U.S. Investment Companies (http://www.ici.org) monthly data show that, since mid 2008, investors have been redeeming money from equity funds and taxable Money Market Fund (MMF) holdings, and increasing holdings in taxable as well as municipal bonds.

In the first six months of 2010, the net cash outflow from taxable MMFs was a staggering $509.2 billion. The largest net inflow of $136.5 billion went to taxable bond funds. The other net cash inflows were: $19.2 billion to municipal funds, $13.4 billion to hybrid funds, and $8.9 billion to equity funds.

Summing up all cash flows, it is apparent that, out of $509.2 billion redeemed from MMFs in the first half of 2010, $331.2 billion left the mutual fund sector. My guess is that some of it has been re-invested in bond ETFs and closed-end funds, and some just used to help pay the bills.

One of the favorite bullish arguments from cheerleaders on Wall Street is to envisage the cash outflow from trillions held in MMFs into stocks. But that has not happened; the money taken out of MMFs has gone into bonds funds.

Investors have been doing what they tend to do, rushing into overheated markets. After getting caught in the hi-tech bubble in 2000, the housing bubble of the mid 2005 and the stock market bubble of 2007, investors are now running to the bond market trap.

Direct holdings of 10-year Treasuries earning a meager 2.5%, while taking on the risk of an eventual rise in inflation, at least guarantee the return of principal face value, and nothing more. That is not the case with bond funds as they trade like stocks. Higher inflation rates will eventually mean higher interest rates and an inevitable downtrend in bond fund prices.

Getting back to the stock market, I see no new technical evidence to modify my view. That is, the market continues to develop a large head-and-shoulder top. The index that is closest to the downside break of its head-and-shoulder neckline is the Russell 2000. Currently, the approximate price levels of neckline breakouts for the leading indices are: the S&P 500 at 990-995, the NASDAQ Composite at 2,050.

For what it’s worth, under the Fed’s frantic money printing, my lead stock market gauge (a proprietary market direction indicator I developed almost 30 years ago) remains frozen in the neutral zone. The monetary part of that indicator is obviously bullish; the sentiment group is at a dead neutral while the technical group is the weakest component.