September 2012 QE3 What Does it Mean to Me? And What is Quantitative Easing Anyways!?

The Federal Reserve announced last week that they would begin a third round of Quantitative Easing (QE3). The much anticipated announcement sent waves of excitement through the investment markets. The US and Global stock markets each leapt on the news, and commodities especially gold, silver and oil almost instantaneously jumped in price. The timing for the next round of QE, and whether or not the Fed was actually going to even embark on more QE has been hotly debated over the last months. QE3 was by no means a done deal, there were a number of prominent economists and analysts who insisted that QE3 would not and should not happen, and even inside the Fed itself, some of the regional presidents expressed their opposition to more QE. In a moment that will be hard to live down, a well-known commodity analyst made an announcement two weeks ago that the Fed definitely would not print more money, and advised all his clients to sell their silver and gold and short their positions. Ouch as Maxwell Smart used to say, Missed it by that much! (in case you dont remember Get Smart http://www.youtube.com/watch?v=E4eUa8owgTE&feature=related Our last newsletter highlighted some recent events which pointed out the proclivity of the US and other developed nations to try and print their way out of their financial woes. We have been encouraging families to work to protect themselves against this trend, and building portfolios with the goal of diversifying against and even trying to profit from ever increasing money printing.

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What Does QE Mean to Me? When governments and central banks print more money several things tend to happen. First, the value and thus the purchasing power of the currency tends to fall. The more abundant an item is, the less value it has, and printing huge amounts of money dilutes and debases the currency. Secondly, the price of assets like stocks, real estate, commodities and especially gold and silver tend to rise when money printing is rampant. The more money that is available to purchase these investments, the more their price tends to rise. Finally inflation is sometimes the end game result of excess money printing. Again the more money in the system, the more dollars it tends to take to buy even everyday goods like bread, meat, milk and other necessities of life. If we observe and believe that the trend (at least for now) is for continued money printing, like QE3, then we may want to lean our portfolio towards that scenario and include an allocation to investments that have a history of doing well in that type of environment. That has been our recommendation and portfolio design since about 2003, and at least for now, we continue to believe that most portfolios should continue to follow that kind of diversification strategy. An investor with an allocation to those types of investments in their portfolio has a big smile on their face after last week!

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What is QE Anyways?

The simple answer LOTS more debt. This is a very relevant time to revisit this subject so we can best understand what QE actually is and how it works. QE may have a monstrous impact on each of our financial futures it is vital that we comprehend and grasp what Quantitative Easing really is. I wrote an explanation of QE back in November 2010. QE How Will the Feds Financial Experiment Work? was one of our most popular and well read articles of the last twenty years, and is reprinted in its entirety below my signature block. We hope that it is timely and helps shed some light and clarity on last weeks Fed announcement. The uncertainty surrounding QE3 and how it may impact investments, the USD and inflation emphasize an investors need for a well-diversified portfolio, a method for drawing predictable income from our assets, and strategies for coping with potential future inflation issues we discuss regularly with all of our clients. I look forward to our next meeting, and of course please feel free to call us if you have any questions before your next appointment. Warm regards, William R. Gevers Financial Advisor

QE3 What Does it Mean to Me? And What is Quantitative Easing Anyways!?
September 2012 Gevers Wealth Management, LLC Page 4 PS: We have been repeatedly asked by clients if they could share these e-mail notes with their friends or neighbors. Please feel free to forward this with the stipulation that it may only be forwarded if done so in its entirety with no portions omitted. We would be delighted to share our comments and opinions with your friends, and welcome your comments and feedback. If you received this and would like to be included on our newsletter list, please email us at wgevers@geverswealth.com PPS: Please look below for QE How Will the Feds Financial Experiment Work?

Copyright 2012 William R. Gevers. All rights reserved.

Gevers Wealth Management, LLC I-90 LakePlace Center 1605 NW Sammamish Road, Suite 250 Issaquah, WA 98027 Office: 425.657.2238 Fax: 425.657.2138 E-mail: wgevers@geverswealth.com
The views are those of William Gevers, Gevers Wealth Management, LLC, and should not be construed as individual investment advice. All information is believed to be from reliable sources; however, no representation is made as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. Investors can not invest directly in an index. Please consult your financial advisor for more information.

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(THIS WAS ORIGINALLY PUBLISHED IN NOV. 2010 AND IS REPRINTED IN ITS ENTIRETY)
November 2010

QE How Will the Feds Financial Experiment Work?

A long time and dear client asked me last week to let him know if a significant economic event should occur that he should be aware of. I told him that Quantitative Easing (QE) is that significant event. The Federal Reserve recently confirmed weeks of speculation and rumors by announcing the start of a second round of QE. The Fed revealed their plans to purchase $600 Billion of US Treasury Bonds over the next several months in an effort to stimulate the economy. Lets review what QE is and how it might impact us as Americans and investors.

QE: What it Is
The US Government runs at a (huge) deficit. A deficit simply means that government spending exceeds its revenue (taxes.) If the US government only spent what they collected in taxes, there would not be a deficit. Unfortunately, over the last decade the annual deficit has ballooned out of control to over a Trillion dollars per year. Our government has and is spending itself into a deeper and deeper canyon of debt. By comparison, if your family or mine acted in that way and spent far more than we made each year, we would soon be penniless and homeless.

(A value above the line means that the US government spent more money that year than it collected in taxes. Notice how much the US annual deficit has grown since 1970, and quite dramatically over the last few years.)

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To make up for its deficit and come up with money to spend, the US Treasury about once per month offers US Treasury Bonds for sale a solicitation to borrow money to fund the governments budget. Again to make a comparison to you or I it would be as if we had to borrow more and more money on our credit cards each month just to keep paying our bills. The US selling Treasury bonds is directly analogous to a family running a higher and increasing balance on their credit cards to stay afloat. Imagine what would happen to that hapless debt ridden family if the interest rates on their credit cards were to increase. They might become even more hopelessly mired in debt. The US relies on the interest rates on its debt (US Treasury bonds) to remain low. If rates on US debt were to increase our countrys deficit would be even more enormous than it already is! The rates on US debt are set and determined by the amount of demand at the monthly auctions the more demand to buy Treasurys, the lower the interest rates are. The typical and largest buyers of US debt are other countries (especially China and Japan.) Other large buyers are pension funds, insurance companies and other institutional investors. If these buyers slow down or stop buying Treasury bonds, then demand decreases which would almost instantly cause interest rates to rise. And this is where QE comes in The simple definition of QE is a government lending money to itself. Here is how it works; one part of the US government, The Federal Reserve, lends money to another part of the US government by buying US Treasury bonds at the monthly auction. (Note that Fed is not officially part of the US government, but operates as a de-facto branch.) Kind of makes your head spin when you try and comprehend it. How can a government borrow money from itself? The answer; the Fed prints new money to pay for the purchase of these Treasury bonds. QE is a surreptitious method of printing money, and due to the huge scale of QE, has contributed to a mind boggling increase in the amount of US dollars.

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Its All a Big Experiment

As one considers the bizarre economic state of the globe, where the worlds most powerful and once wealthiest nation is now so deeply in debt that it must borrow money from itself in order to pay its bills, you might wonder how will this all turn out? There is really no historical precedent in US financial history for what we are doing. The Fed is conducting a grand financial experiment on a massive scale, and no one is sure exactly how it will turn out. We do know however what the Feds objectives are and we can identify some areas of the economy and markets that may be greatly impacted by QE. The Feds hoped for policy goals for QE is to; keep interest rates low, increase asset prices of stocks and homes, and stimulate the economy and job growth. Those are all admirable goals to be sure. Lets review these Fed objectives and some other areas where QE might have a major impact.

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Stocks & Real Estate Prices Reflation?

The US is committing to print an extra $600 Billion dollars of new money. Where will all that new money go? The Feds goal and a likely scenario is that some of that cascade of new dollars will flow into the stock market and real estate. Economists call this reflation; an attempt to pump up prices of investment assets via money printing. The Fed is hoping that this new cash will inflate values and thus spur economic growth. Many investors find this concept distasteful and a manipulation rather than true investment. Nonetheless, a gain in our portfolios is a gain no matter the source. The possibility that the Feds massive money printing via QE will push up stock prices underscores the importance of having at least part of ones portfolio diversified into stocks and also the importance of rebalancing periodically and harvesting gains in such an uncertain environment.

Interest Rates How Low Can they Go?

Remember that US Treasury bond rates are set at the monthly auctions based on the amount of demand for those bonds. Because the Fed, through QE, is a massive buyer of those bonds, demand is very high and thus rates are low. For example the recent rate for a ten year treasury bond has been in the mid 2% range; a buyer of US ten year debt will get a little over 2% per year interest on their loan to the US government. This is an extremely low rate, and as a result home mortgages and other types of loans are also at levels that none of have seen in our lifetimes. The Fed clearly has been successful so far at keeping rates very low.

(http://research.stlouisfed.org/fred2/series/DGS10)

QE3 What Does it Mean to Me? And What is Quantitative Easing Anyways!?
September 2012 Gevers Wealth Management, LLC Page 9 The Fed is trying to encourage consumers to borrow money at these incredibly low rates and spend money on homes, cars, and other large ticket items, which they hope will then stimulate the economy. If interest rates are higher, than the policy makers at the Fed fear that people will be less likely to purchase cars and homes and further weaken the economy. The astute observer might ask, what will happen once QE ends and the Fed stops buying US bonds? A rubber band can be stretched if the proper pressure is applied but when the pressure is released the rubber band snaps back to its original shape. In the same way it is believed that when the Fed ceases QE and its purchases of US bonds, than just like that rubber band, demand will snap back to its original (lower) level and as a result interest rates would soar. Will that happen and when will it happen? No one knows of course. One thing that seems to be clear, the Fed is fully committed to using QE, and it is possible that rates may stay quite low as long as they keep following that policy. Quipped an economist about the Fed and interest rates, Never underestimate the power of the printing press!

The US Dollar Will QE Weaken It?

The US Dollar is perhaps at great risk due to possible adverse impacts of QE. The reason is really quite simple the more abundant something is, the lower its value tends to be. The US by printing excessive amounts of dollars has diluted its value. In addition, by going ever deeper into debt, the US has begun to erode its credibility that it will be able to repay, and so a holder of a USD, especially one outside of our country, might begin to wonder what value that piece of green paper really represents. Not surprisingly the value of the USD has dropped dramatically over the last ten years coinciding exactly and simultaneously with the meteoric rise in money printing and the rapid increase in the US deficit. (Please see the chart below.)

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By contrast, when I graduated from college in the 1980s, the USD was very strong. Some of my UW classmates bragged of spending an entire summer in Europe on only a few hundred dollars partly because the USD was able to purchase so much overseas. Today travelers to Europe complain of a $10 dollar cup of coffee or a $100 lunch, a symptom of a much weaker USD. Although it is likely that QE will further weaken the dollar, a bizarre phenomenon is manifesting around the globe as a direct response to the US QE policy. Other countries are taking measures to weaken their own currencies which economists call competitive devaluation, and one humorist wryly dubbed, a race to the bottom. Why would a country purposely try to weaken its own currency? It is because the US is the worlds largest consumer and the weaker the USD is, the more difficult it becomes for importing countries to sell goods to us. In other words, the weaker the USD, the more expensive it is for US consumers to buy Japanese stereos, German cars, Swedish furniture, and Chinese everything. Warren Buffet was interviewed recently about his thoughts about the USD and competitive devaluation. When the interviewer asked him which currency he preferred, Buffet replied, The US Dollar is the worst of the worlds major currencies except for the rest of them. A continued decline in the value of the USD has many possible negative ramifications for us, including higher interest rates and higher prices in our country.

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Gold & QE, Up, Up and Away

Perhaps one of the biggest surprises to many market observers has been the dramatic increase in the price of gold over the last decade.

(Price of gold over the last 20 years. Compare this graph to the one of US deficits above. Notice that the price of gold started to rise in about 2001 the same year that deficits started their dramatic increase.) (http://www.usagold.com/gold-price.html) Gold is difficult to comprehend as an investment it does not pay any interest, have any earnings or profit, does not pay rent or a dividend. Gold fails all the tests of an investment and as a matter of fact gold is not an investment. Gold is a type of money and a store of value. When you think of gold in those terms, it becomes easier to understand why the price of gold is increasing. When conventional money, which for us is the USD the green paper in our wallets suffers a loss of confidence and weakens, then holders of dollars quite naturally move to a different type of money, gold. During periods of low confidence or financial crisis, it is common for gold to be used as a store of value rather than paper currency, and so the increase in the price of gold. Or stated another way, the more paper dollars that a government prints, the more of that paper it takes to exchange for an ounce of gold. It is not surprising then that the price of gold has risen so much given the tremendous amount of paper dollars that the US has been printing over the last several years. What will gold do going forward? When you consider the amount of additional money the US has already committed to print in the coming months and years, it confirms a portfolio diversification strategy that includes some gold.

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September 2012 Gevers Wealth Management, LLC Page 12 Remember that the recent increase in the price of gold happened during a period of low inflation. What might happen to the price of gold if inflation becomes severe? No one knows for sure, and there are certainly no guarantees for the future. However, if you use the high inflation period of the 70s and early 80s as an example from history, the price of gold during those years rose about 2500%. Investors preferred to hold gold rather than dollars in an environment where the dollar was losing value rapidly due to high inflation.

Inflation Price of Commodities

Gold is not the only commodity that tends to increase in price during periods of inflation. Most commodity transactions, especially those between nations, are transacted in USD. Therefore, when the value of the USD decreases, commodity prices necessarily tend to increase (to US citizens) because it takes more dollars to buy that commodity. (Commodities are the basic stuff of life, and include food staples like rice, corn and wheat, industrial metals like copper, iron and aluminum, and petroleum products like oil, natural gas and coal.) You can see that quantitative easing might very well lead to a weaker dollar which can in turn therefore lead to higher commodity prices, especially those that are denominated or transacted in USD, which in turn leads to higher prices for us here in the US. That's how QE can lead to price inflation. The other way that QE leads to inflation simply has to do with too much money. Milton Friedman, a renowned Nobel winning economist said that inflation is and always has been a monetary fiscal phenomenon. In other words, when the government prints too much money there tends to be inflation. Remember QE is a back door method of printing money in staggeringly large amounts. It is this scale of dollar creation that Milton Friedman and history suggest that very often leads to inflation in the future.

(http://research.stlouisfed.org/fred2/graph/?s%5B1%5D%5Bid%5D=AMBNS)

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We have not seen a great deal of inflation as of yet and my hope is that we never do. Unfortunately the probability of our country experiencing high inflation increases with every new round of money printing that the government implements. Inflation is a danger we need to consider carefully in our financial lives and in our portfolio diversification plan.

Attempting to stimulate the economy via monetary policy like QE is making a "bargain with the devil."
Thomas Hoenig, President Kansas City Fed

So, how will the Feds financial experiment turn out? What will be the eventual impact and consequences of QE? The economic and investment uncertainty we all face today emphasizes the need for an investor to have a well-diversified portfolio, a method for drawing a predictable income stream, and strategies for coping with future potential inflation issues we have been, and are discussing regularly with our clients. I look forward to our next meeting, and of course please feel free to call us if you have any questions before your next scheduled review.

Warm Regards,

William R. Gevers Financial Advisor

PS: We have been repeatedly asked by clients if they could share these e-mail notes with their friends or neighbors. Please feel free to forward this with the stipulation that it may only be forwarded if done so in its entirety with no portions omitted. We would be delighted to share our thoughts and opinions with your friends, and welcome your comments and feedback. If you received this and would like to be included on our newsletter list, please email us at wgevers@geverswealth.com

Copyright 2010 William R. Gevers. All rights reserved.

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US Money Supply, US Dollar, and Inflation/Deflation Watch

US Money Supply Adjusted Monetary Base

(http://research.stlouisfed.org/fred2/graph/?s%5B1%5D%5Bid%5D=AMBNS#)

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US Dollar Price (DXY) USD Index Measured against Other Currencies

(http://barchart.com/chart.php?sym=DXY00&style=technical&template=&p=MC&d=H&sd=01%2F01%2F2000&ed=

&size=M&log=0&t=LINE&v=1&g=1&evnt=1&late=1&o1=&o2=&o3=&sh=100&indicators=&addindicator=&subm itted=1&fpage=&txtDate=#jump)

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Inflation/Deflation -Year to Date Price Increase in Commodities and Basics as Measured by Futures

(http://www.finviz.com/futures_performance.ashx?v=17)

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September 2012 Gevers Wealth Management, LLC Page 17 Velocity of Money

Velocity is a measure of how quickly money is spent. High velocity is typically a precondition for inflation. (http://research.stlouisfed.org/fred2/series/MZMV)