Friday, September 14, 2012

Profit from the Fed and ECB

Last week, the ECB announced that it would spend as much as needed to contain borrowing costs in euro-area countries ifthey sign up to bailout conditions first.  At first glance, it sounds a lot like the ECB is going to turn on the printing presses, which should weaken the euro.  But, that isn’t what happened at all.  Instead, the euro has strengthened rapidly against the U.S. dollar, as investors have apparently rushed in to take advantage of the higher yield on euro bonds that now seem to be a whole lot less risky.  The ECB even remarked today that it may not need to buy any bonds, but of course, that depends on whether the market continues to buy.

Subsequent to the ECB announcement, the Fed announced its own version of unlimited buying, the target being mortgage backed securities, with a somewhat different result.  The markets for risky assets have surged, while the dollar continues to slide against the euro.  What one might have expected is a drop in mortgage rates, but that isn’t really the case, since mortgage rates are already low.  Instead, it appears that investors are moving money from relatively safe, low yield, investments into riskier investments.  The Fed has artificially raised the investment demand for mortgages, which would lower the yields on those investments, except that other investors then, seeing the low mortgage rates, choose to invest in some area where the returns are higher.  The result: a big pop in stocks, for one.  It is somewhat like the Fed is investing indirectly in the stock market, effectively “crowding out” other investors from relatively safe investments into more risky assets.

The longer term effects of both these actions are hard to quantify, but I think the result will be a continuing surge in stock prices here in the U.S., assuming we don’t actually enter into a recession, and a continued weakening of the dollar against the euro.  The reason for the weakening is clear: the Fed has said it will buy $40 billion in mortgage backed securities until the employment situation begins to pick up.  The ECB, on the other hand, has actually said that they may not need to do any actual bond purchases.  So, the Fed will be turning on the printing presses, while the ECB may never need to, although in the longer term, they too will likely need to if economic conditions don’t improve in Europe.

So, the question that needs to be answered is, “How can investors profit from these actions?” Just considering these two actions, the best thing to do is to invest in European companies that are not dependent on exports, particularly to the U.S. since European goods are going to become significantly more expensive here in the U.S., while the opposite is true for U.S. goods in Europe, at least in the near term. The best investments here in the U.S., in my opinion, are in companies that have significant exports to Europe, since the exchange rates are moving in a way that is favorable to U.S. exporters.