Perhaps it is appropriate that the name of the latest attempt by the Federal Reserve to “print our way to prosperity” shares a name with Cunard Lines’ famous flagship, the Queen Elizabeth 2.

QE2 and Statue of Liberty

The QE2 was launched in 1967, just under three years before the commercial launch of the Boeing 747. While the QE2 was renowned as the most luxurious way to cross the Atlantic, she was an anachronism in the “jet age” which had already started in the late 1950’s.

The Federal Reserve, under Mr. Bernanke’ s guidance, looks poised to launch the just the wrong kind of ship, Quantitative Easing, Part 2 (aka. QE2). While there was little doubt that the financial system needed a liquidity injection in the dark days of the Global Financial Crisis in 2008, one wonders what use further money creation will serve in a financial system that is not demanding more money.

What we as investors need to do is:

  1. Understand why this is happening.
  2. Adjust our portfolios to take advantage of the newly created money.

We do not need to struggle with the question of whether QE2 is good economic policy. The answer is simple: it is not. As Vincent Reinhart told Bloomberg:

“If you were to write down a list of the 15 things that could come out of Washington to help sustain the recovery, quantitative easing is 15th on the list,” Reinhart said. “The problem is that items 1 through 14 are off the list because they involve tax policy, changing the laws. Nobody realistically thinks that’s going to happen.”

If you want a pretty good analysis of the situation, try Mr. Mauldin’s Outside the Box post for this week. If you want to read a more positive view, Stratfor thinks this is all a set up for the G20 in Seoul.

Why is this happening?

Because the Federal Reserve can get away with it.

The US economy, not unlike other developed economies, is in need of fiscal, financial and structural reform. These reforms are painful because they must be implemented in a crisis. The joke, however, is that reforms are rarely contemplated when times are good, so reforms almost always fall due during a crisis.

The choices are stark. The US suffers from massive fiscal and current account deficits. Unemployment is high, demand is low and businesses are hording cash. Rather than raise taxes, reduce spending or promote investment in export oriented businesses, the Federal Reserve is determined to devalue the dollar. Using the laws of supply and demand, one simple way to do so is to increase the supply of dollars well beyond what is demanded.

If successful, the US government can settle its obligations (aka Treasuries) with cheaper, more plentiful dollars, imports will become expensive enough to encourage domestic substitution and US products will find new export markets.

Problems solved? Maybe. However, it would be safer to bet on something called “unintended consequences,” which will surely throw a massive monkey wrench into the Federal Reserve’s plan.

Portfolio Adjustments – follow the money

The next question is what should we do to our portfolios? Let’s look at one example in Asia. Check out the rating difference between FXI (the Xinhua 25) and EWH (MSCI Hong Kong).

As mentioned above, there are sure to be strong reactions to this blatant act of currency sabotage. China is vulnerable no matter what it does. If it agrees to let the RMB float upwards, it threatens to wipe out the narrow operating margins its exporters operate on while taking an immediate hit to its foreign exchange reserves. For a country that was recently poor and saw the way the Asian Financial Crisis ravaged the economic landscape, neither of these are attractive points of contemplation. Of course, if the People’s Bank of China tries to hold the exchange rate, there is little doubt that the US congress will initiate some sort of trade war.

So, if you don’t feel like loading up on Chinese equities today, the Fund King System is showing you that there may be a better way to play in the neighborhood. Hong Kong, for example, might be just the ticket. With a hard link to the US dollar (which will drive interest rates even lower) and a fast trading property market (which serves as a piggy bank for the locals and wealthy Chinese over the border), the excess money created by Mr. Bernanke looks poised to flood in and push asset prices further in Hong Kong.

Other ways to play?

With the developing markets growing faster than the developed markets, a load of fresh dollars hot off the printing press and looming trade and currency wars, the one thing we can be certain about is that there will be more market volatility, asset class and sector rotation. The Federal Reserve’s actions will have repercussions around the financial world as companies, central banks and investors react. Don’t forget that QE2 is one of the most anticipated Fed moves in history. Many of the bets one would associate with QE2 are already laid on. Keep an eye out for profit taking and reversals (even the US dollar) which are very likely in the coming weeks. As we enter the final two months of the year, it makes sense to pay extra attention to your portfolio and be ready to rebalance. Don’t be shy about locking in profits.

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Filed under: CurrencyInflation/DeflationInterest RatesMarket Psychology

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