How to play the end of QE2

Strategists share their views on where to invest when the Federal Reserve ends its $600 billion bond-purchase program.

By TheStreet Staff Apr 7, 2011 11:39AM

the streetBy Shanthi Bharatwaj, TheStreet


Quantitative easing, which has kept yields on bonds artificially low and has investors flocking to risky assets such as stocks and commodities, is widely expected to end in June.


But market analysts say investors should continue to bet on stocks and commodities even after the Federal Reserve ends its $600 billion bond-buying program -- known as QE2 -- as bonds will prove to be an unsafe alternative.


A combination of recovery expectations, inflation risks and worries about the massive federal deficit have been pressuring bonds and lifting yields -- bond prices and yields share an inverse relationship. But with the Fed stepping in to buy up Treasury notes, analysts say the rise in yields has been relatively modest. The intention of the Fed's purchases is to dampen interest rates so as not to threaten an economic rebound.


However, once QE2 ends, bonds could sell off further, causing yields to climb higher. And the central bank might have to hike short-term interest rates eventually as economic growth returns and inflation spikes, hurting bonds further and making them an unsafe investment.

The biggest bear signal for bonds yet came last month when Bill Gross, the renowned manager of the world's largest bond fund at Pimco, exited Treasuries and increased his holdings in cash.


While rising interest rates would normally pose a threat to stocks, analysts say that is not an issue in the near term. With the federal funds rate near zero, it would take significant monetary tightening to dim the attractiveness of stocks.


James Dailey, the chief investment officer of TEAM Financial Managers, expects central banks across the world to be slow to raise rates, making commodities and commodity-related stocks a good bet even after QE2 ends.


"The damage has been done. We have seen a pickup in the inflation cycle," Dailey said. "It is not just the Fed pressing the accelerator. It is the Bank of Japan and the European Central bank. I don't think there is going to be any draconian tightening anywhere."


"Even if we see tightening, that is no reason to not own commodities," he added. "Central banks will be behind the curve. You can get corrections based on it being overbought now, but the fundamentals are intact. Unless there is a global recession or one or more central banks find religion and develop a Volckeresque appetite for monetary tightening, we see negative real yields."


Dailey says he favors commodity-related stocks in agriculture, energy and precious metals. "Energy stocks are going nuts right now, but they are still pricing in $90 oil. So even if oil plateaus at this level (near $108), those stocks are cheap."


The analyst also prefers blue-chip names that are trading at low valuations, such as Microsoft (MSFT), Dell (DELL) and Hewlett-Packard (HPQ), as well as consumer companies like Wal-Mart (WMT) and Procter & Gamble (PG) that might be better placed to pass along higher input costs. (Microsoft owns and publishes MSN Money.)


He is relatively less bullish on industrials such as Caterpillar (CAT) and Deere (DE). "Those stocks have largely priced in the optimism. Valuations are risky and are based on the premise that profit margins will stay high," Dailey said.

While Dailey expects selective stocks to do well post-QE2, Phil Orlando of Federated Investors says an end to QE2 in June would be positive for stocks overall. "The market is going to rip on the idea that the Fed is starting to normalize policy after three years. It will tell investors that the Fed is confident about the economy sustaining itself on its own. And stocks are cheap."


Orlando is bullish on stocks that are leveraged to global growth -- tech, financials and energy -- while he recommends de-emphasizing low-growth sectors such as utilities, consumer staples and health care.


Gold is also expected to do well, as the end of QE2 is unlikely to put inflation worries and concerns about the fiscal deficit to rest. Investors are worried that the government will postpone making tough decisions on spending until after the elections and would continue to resort to policies that weaken the dollar. "I don't see any policy alternative out of Washington outside of inflation," Dailey said.


John Mauldin, the president of Millenium Wave Advisors, continues to buy gold for protection, as the market could still suffer from exogenous shocks such as the sovereign debt crises in Europe or a slowdown in Japan.


"I am buying gold every month. Not because I am a gold bug. But after what I have seen in the last few weeks, and I have been talking to political leaders, it's making me very nervous," Mauldin said, referring to the political stalemate over the budget.


"Gold is not an investment for me, you understand," he continues. "It is something I need to buy because I want something sitting in my vault if things go wrong. It's insurance."


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Apr 7, 2011 3:16PM

I don't subscribe, in the least, to any of the cheery optimism posed in this article.  Interest rates will rise and keep rising and then watch the worsening effects on the already abysmal housing market.  It is difficult to get a loan now at current rates so just wait until interest rates continue to rise.   Foreclosures will continue to rise as property values continue to plummet causing an even worse scenario.

This government shut down is the canary in the coal mine.  Both parties still refuse to get serious about reigning in spending.  The republicans proposal will shave off only 4% of the 2011 budget even if they get their way.  Both parties have and it appears will continue to spend our country into oblivion and rack and ruin.  They are not remotely serious about ever balancing the budget and we will soon have hyper inflation brought on by the Feds to the likes of which this country has never seen before.  So batten down the hatches and get ready for some mighty lean times in the once prosperous good ol' USA!  This is beyond serious folks. 

Apr 7, 2011 1:15PM

The age old question, where to put your fiat when everything is going down? Bonds? down Stocks? down Real Estate? down


The answer is off shore in places where inflation is being controlled. They will come out of  their duldrums before we do as we are just getting started. I like having wind in my sail. It helps you go places while others are dead in the water.

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