Concern: Who Will Buy U.S. Treasuries if the Fed Exits Quantitative Easing?

One of the biggest debates amongst American economists these days is whether the Federal Reserve’s continued $85.0-billion-a-month expansion of the money supply is making the U.S. economy more vulnerable, as opposed to helping strengthen the economy. One of the main reasons the central bank took on quantitative easing in the first place was to revive the financial system following the housing slump. After a $3.0 trillion increase in the Fed’s balance sheet, should the central bank put the brakes on money printing?

Federal Reserve Governor Daniel K. Trullo said late last week, “Significant increase in both the quality and quantity of bank capital during the past four years help ensure that banks can continue to lend to consumers and businesses, even in times of economic difficulty.” (Source: Federal Reserve, March 7, 2013.)

While this may be good news, I am more concerned about what may be next—the “exit” of a monetary policy, which in the eyes of many has now gone on for too long. As noted above, through quantitative easing, the Federal Reserve has added a significant amount of assets to its balance sheet.

How will it decrease its balance sheet and bring it back to historical levels? On one hand, the idea is that the Federal Reserve can continue to hold the bonds it has bought until maturity. On the other hand, the option is to go out into the open market and sell the bonds it has accumulated.

While these options sound feasible, I see them as troubling. If the Fed sells the bonds it has in the open market, then the prices of bonds will collapse due to an increased supply. A simple rule of economics: when the supply increases, prices go lower. In addition, it could cause borrowing costs or interest rates to rise significantly if there are no takers for the bonds. On the other hand, if the Federal Reserve holds its bond purchases until maturity, such action may be taken as an indication that there are no buyers for the bonds, thus, the Fed is forced to hold onto them—this creates investor uncertainty, which is bad for any market.

What it boils down to is that the Federal Reserve may not have many choices when it comes to unloading all the bonds it has accumulated. As I have been saying in these pages, the longer quantitative easing continues in the U.S., the bigger the troubles down the road.

What I won’t be surprise to see is the Federal Reserve continuing its bond buying operation, because quite frankly, I’m not sure how many buyers of U.S. Treasuries we would have if the Fed was not in the market buying them.

So what’s an investor to do with all this uncertainty about what happens next with quantitative easing? No matter what the Federal Reserve’s next action may be, I continue to see gold bullion as a hedge against quantitative easing and an expansive monetary policy.

Where the Market Stands; Where It’s Headed:

The stock market is becoming severely overbought. My indicators show that the market is reaching a top, not starting a new bull market (as I have read from others). I urge caution with stocks.

What He Said:

“In 2008, I believe investors will fare better invested in T-Bills as opposed to the stock market. I’m bearish on the general stock market for three main reasons: Borrowing money in 2008 will be more difficult for consumers. Consumer spending in the U.S. is drying up, which will push down corporate profits.” Michael Lombardi in Profit Confidential, January 10, 2008. The year 2008 ended up being one of the worst years for the stock market since the 1930s.

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