By Jeff Jones, MBA, Ph.D
Near the end of 2013, the Federal Reserve announced it would begin the process of winding down its highly controversial program known as “Quantitative Easing,” or “QE” for short.
The current version of QE is the third round of the program, and as such has been appropriately dubbed “QE3.” Simply put, QE is a special form of monetary policy whereby the Fed makes strategic purchases of fixed-income securities in the open market, generally from financial institutions.
When the Fed makes this type of purchase, it accomplishes two things.
First, it raises the price, which in turn lowers the interest yield on the fixed-income securities. Second, it removes the securities from the asset section of the financial institution’s balance sheet and replaces it with cash, which the financial institution can now use to make more loans.
This is how the Fed is able to effectively “print” money. It buys the fixed-income securities using “new” money it has created. Once the purchase is made, this new money is now part of the money supply. An expanded money supply results in lower interest rates, which in turn encourages consumption and capital investment that stimulate overall economic activity.
So what does the end of QE mean for you and your portfolio? I would like to discuss four areas of concern for the average person: the bond market, the stock market, borrowing costs and interest rates on savings.
The bond (fixed income) market: Bond prices are inversely related to changes in interest rates. As QE3 winds down, longer-term interest rates should rise and the prices of bonds will fall, putting pressure on overall bond returns in the near future. The fall in price is more severe the longer the maturity of the bond. If you must hold bonds as part of your overall portfolio, it may be prudent to choose bonds with a shorter time to maturity.
The stock market: Once interest rates rise and bond prices fall, this potentially makes the bond market relatively more attractive to the stock market sometime in the future. In addition, rising interest rates increase borrowing costs for businesses, which will cut into profits. Both factors would be bad for stocks. However, the Fed’s willingness to begin winding down QE3 signals that the overall economy has and is continuing to improve, which is good for stocks. I expect the stock market will be up again in 2014, but nowhere near the returns experienced in 2013.
Borrowing costs: Home mortgage rates have already increased by nearly 1 percentage point in 2013, and I expect this trend to continue into 2014. So if you are planning on borrowing to buy a house, car or expand your business, it may be prudent to get this done early in 2014 before rates rise any further.
Interest rates on savings: QE3 has focused on purchasing mostly longer-term securities, hence its end will influence mainly longer term interest rates. Rates on savings tend to be more closely tied to short-term rates, which are unlikely to rise much in the next few years. So, unfortunately, don’t expect to see larger returns on your savings accounts or CDs anytime soon.
Jeff Jones, Ph.D., assistant professor of finance at Missouri State University, is a Chartered Financial Analyst, Certified Public Accountant, Certified Management Accountant and Certified in Financial Management.
This article appeared in the March 16, 2014 issue of the Springfield News-Leader. It is available online here.
Views expressed in this article reflect those of the author, have been distributed for educational and informational purposes only, and should not be construed as investment advice or a recommendation of any specific security, strategy, or investment product. Email: email@example.com.