The Fed telling us there is no QE3 is like a vegetarian eating short-rib ravioli or pork eggrolls. Just because you can't 'see' it doesn't mean it's not there.
True, there is no QE3 (yet) in the form of QE1 or QE2. QE stands for quantitative easing and quantitative easing happens when a central bank buys financial assets to inject money into the economy.
Even though it's not called QE3, the Fed is right now making billions of dollars available to buy financial instruments. We're not talking about Operation Twist here; we're talking about a covert operation that's essentially a U.S. bailout of Europe.
Covert Doesn't Mean it Doesn't Exist
You probably heard of the 'temporary U.S. dollar liquidity swap arrangement.' This arrangement, which the Federal Reserve has with the European and other central banks, sounds innocent enough.
Before we go on, keep in mind that the European Central Bank's (ECB) constitution does not allow the ECB to print money and use it to buy government bonds (such as Greece, Italy, Spain, Portugal, etc.).
The dollar swap agreement with the Fed however, allows the ECB to circumvent its constitutional prohibition to buy extensive amounts of European debt. The Federal Reserve acts almost as a money launderer and helps the ECB to keep face. The 'benefit' of buying bonds from struggling governments is that it keeps interest rates low and manageable.
How Does it Work?
Why doesn't the Fed just lend money directly to U.S. branches of foreign banks? For one, the Fed's gotten embarrassed by the 'secret' files showing its prior largess with foreign banks. Also, it doesn't want the debt of foreign banks on its books (at least not officially).
Which European government wouldn't want the ECB to bail out Europe? The ECB covertly does what political leaders want it to do and political leaders won't cry foul. It's easy to look the other way when there's a unanimous consent.
Instead of engaging in an official version of euro-QE, the ECB borrows money from the Federal Reserve and lends it to euro banks. Banks in turn are urged to buy European government bonds.
It's a great deal for European banks (at least at first) because they pocket bond returns north of 4% and get the loan on the cheap (1%). The ECB or Fed will no doubt cover any defaults, so it's a risk free margin.
What's the Scope?
In addition to the money shipped to Europe from the U.S., European banks can count on unlimited three-year, 1% loans from the ECB. In December, banks borrowed $638 billion from the ECB.
The dollar swap agreement doesn't get much attention here, but Germany's Frankfurter Allgemeine newspaper reported that euro banks took three-month credits worth $33 billion, which was financed by a swap agreement between the Fed and ECB.
In the fall of 2008, the Fed had more than $600 billion of currency swaps on its books. By January 2010 those draws were largely paid down, but in mid-December it jumped back up to $54 billion.
In addition to the amounts mentioned above, the Fed uses money from maturing securities on its balance sheet to buy Treasuries (NYSEArca: TLT - News) from U.S. banks (NYSEArca: KBE - News). I consider this QE2 light. The chart below compares the monthly inflow of QE2 with that of QE2 light. If you add the amount of unlimited ECB loans and dollar swap loans to QE2 light, you have an almost full grown QE3.
Clearing up QE Misconceptions
When looking back at QE2, most investors will remember a relentless rally, and that's true. However, the QE2 rally wasn't as straight up as many remember.
The chart below shows that the S&P's performance during the November 2010 - June 2011 'QE2 rule' was quite volatile. In fact, QE2 was greeting with a pretty nasty decline that took the pattern of a W.
The December 12, 2010 ETF Profit Strategy update forecasted a measured W pattern breakout target of 1,281. We know today that the S&P (SNP: ^GSPC - News), Dow (DJI: ^DJI - News), Nasdaq (Nasdaq: ^IXIC - News) Russell 2000 (Chicago Options: ^RUT) and all other major indexes keep grinding higher.
Nevertheless, starting in mid-February stocks entered a roller coaster period that saw no net gains for five months. Almost a year later, stocks still trade below the February 2011 high.
After successfully navigating the March sell off, the April 2, 2011 ETF Profit Strategy Newsletter stated that: 'Even though odds do not favor bearish bets the first half of April, a major market top is forming. The 1,369 - 1,382 range is a strong candidate for a reversal of potentially historic proportions'.
How To Trade in a QE Market
Even though the strong rally from the October lows makes the May top at S&P 1,371 less 'historic,' it proves that contrarian investing has its place. Based on a slew of confirming indicators, the October 2, 2011 ETF Profit Strategy update said in no uncertain terms that it's time to buy:
'Based on the studies discussed in the August 14 and 21 update, I've been expecting new lows followed by a tradable bottom. I define a tradable bottom as a low that lasts for a few months and leads to a bounce that (in this case) should propel the markets around 20%. From a technical point of view this counter trend rally should end somewhere around 1,275 - 1,300.'
I received a lot of snide remarks and mockery for suggesting the S&P will rally to 1,300, but here we are at 1,320.
Investing is not only about getting things right, it's also about knowing your weaknesses. Already on October 11, the ETF Profit Strategy update warned that: 'This rally is a miniature version of the March 2009 - May 2011 rally. I expect some difficulties in forecasting the exact route of this rally. The coming months could be filled with frustratingly choppy trading with an up side bias.'
Frustrating and choppy trading with an upside bias describes pretty closely what Mr. Market has delivered.
Despite all the frustration in charting the exact route of this rally, the S&P has reached (and exceeded) the initial up side target and is starting to create a sell signal similar to the May 2011 top.
This doesn't mean stocks can't go any higher (a momentum and liquidity market always can), but it suggests (as does the chart above) that holding stocks (NYSEArca: VTI - News) is quite risky. The complacency index - the VIX (Chicago Options: ^VIX) - has reached complacency levels not seen in over six months.
The ETF Profit Strategy Newsletter identifies the next resistance level (similar to the one that ended the May 2011 rally) and how to trade in a manner that maximizes profit potential and minimizes risk.
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