The Death Knell for the Fed's QE Policies

Fellow fool Morgan Housel advises that as investors, we shouldn't focus on month-to-month economic data releases, like the employment report released this week. From an investing standpoint, I tend to agree with him. 

But this month I'm going to dive in anyway.

Not because this report is a buy or sell signal, but because I think this employment report is at last the signal of economic strength the Federal Reserve needs to end its quantitative easing programs. Here's why that matters.

QE was supposed to cause inflation, right?
From the very beginning of the Fed's easing tactics -- the bond buying, the "twist," the second and third rounds of bond buying, the press conferences and prepared statements -- pundits have cautioned at the inflationary risks of these easy-money policies. 

The reality, it turns out, is less stagflation and more Japanese-style deflation! 

The lack of inflation and risk of deflation is partly driven by the depressed demand for loans, reducing the money multiplier effect in money supply and offsetting easy money elsewhere. It's partly driven by ever lower interest rates encouraging buyers to wait for cheaper rates later instead of buying today. It's partly unknown -- the economy is a massive, complex, and sometimes bewildering amalgamation of buyers and sellers around the globe.

Its also being partly driven by the weak labor market. Growth stokes the fires of inflation, and with so many Americans either out of work, underemployed, or fearful of losing their job, consumer demand has been weak. Until the labor market rights itself and consumers pick up their spending, inflation will probably remain low. 

If this week's employment report is any indication, that trend is finally reversing in a meaningful way. More than 200,000 net jobs were added to the economy. The labor force participation rate increased, reversing its years-long decline.

What this means to policy makers is twofold. First, the economy is looking stronger and stronger. This is great sign for the kind of self-reinforcing growth needed to lift the U.S. out of the "new normal." 

Second, it indicates that the risk of deflation is diminishing. Signs of growth plus signs of normalized inflation means the end of QE is very likely coming soon.

The takeaway for Investors
The bond markets will most likely adapt with higher short-term interest rates, particularly so after the tapering game plan is more widely understood and predictable. The Fed has promised to keep its benchmark rates low for the foreseeable future, but the yield curves will probably flatten.

For banks that rely heavily on mortgage lending, these outcomes will probably bring short-term pain, but they will also be a long-term positive. Wells Fargo, JPMorgan Chase, and Bank of America will benefit in the long term from the higher rates increasing revenues and return of normal homebuying patterns, despite the end of the refi boom of the past several years.

The refi boom has already screeched to a halt, driven by the sudden spike in rates over the summer. But the return of consumer demand will help the housing market long term; expect new home purchases to rise along with the decline in the unemployment rate.

Since the Fed began its near-zero rate policy, banks have enjoyed the benefits of very low interest rates paid on checking and savings accounts. Industrywide, the total interest expense (i.e., money paid to depositors) declined more than 86% from Q4 2007, according the FDIC's Quarterly Banking Profile. Total interest income declined only 37%. 

When rates rise, banks will benefit from the higher interest income earned through loans, which will be only slightly offset by the rise in deposit expenses. That's good news for long-term investors of Wells, Bank of America, JPMorgan, and others. 

One month does not a trend make
As investors and economic observers, we should always proceed with caution. This employment report is just one month. The impact of the government shutdown earlier this year could still be sorting itself out in the numbers, potentially inflating the core of the economy.

Be cautious and take the long view. It will take more time to truly see the trend and become comfortable with it. The revisions to this report will be the next indication of the labor market's real strength and trend. 

But in the meantime, take a minute to enjoy a very positive end to the investing work week!