How The Fed Will Affect Your Portfolio This Week

All eyes will be on Ben Bernanke this Wednesday as the Federal Reserve finally spells out the details of its much-anticipated second round of Quantitative Easing, known as “QE2.” [For more on QE2 and how it works, read this article] The Fed‘s efforts to stimulate the economy through bond buybacks have led investors to already open the champagne.

As I noted recently, the S&P 500 has already appreciated by more than $1 trillion simply in anticipation of any presumed benefits. But in recent days, economists are beginning to doubt whether Mr. Bernanke is going to bring out the large cannons, or simply a set of pea-shooters. More specifically, will QE2 be large enough to get the economy going, buying back up to $1 trillion in bonds, or will the Fed believe that a few hundred billion dollars will be sufficient?

#-ad_banner-#A pair of fresh economic data points point to the latter. Last week, we saw a moderate drop in weekly jobless claims that makes it clear that unemployment is at least not getting worse at this point. And then on Monday morning, the Institute of Supply Management (ISM) announced that its manufacturing index shot up to 56.9 (handily above the economic expansion/contraction line of 50.0), which is the highest reading since May.

The ISM figure had been cooling in recent months back toward the 50.0 mark, but the just-released figure represents a fairly bold reversal. Indeed, a separate measure of new factory orders posted an even more robust reading of 58.9, which is good news for the economy, but bad news for QE2. After all, Mr. Bernanke’s original goal with the bond buybacks was to get the economy going and not to simply create party-like conditions for equity investors.

The inflation threat
Mr. Bernanke has another reason to announce a more modestly-sized easing program. Some have expressed concerns that a massive trillion dollar expansion of the Fed’s balance sheet will create eventual conditions for surging inflation. Sure enough, the ISM data also noted an uptick in manufacturing pricing pressures. These pressures usually appear when the broader manufacturing sector is operating closer to 80% (it’s below 75% right now). But in many industries, so much capacity has been taken off-line that they are likely operating well above 80% capacity.

Action to Take –> If the QE2 package is as large as investors expect — in the $750 billion to $1 trillion range, then the markets may well shrug, as that is what investors seem to be anticipating. If the package is any smaller, closer to the $500 billion mark, then investors may look to quickly book profits on concerns that the QE2 will be insufficient to really boost the economy. So we have a likely outcome of either no reaction or a negative reaction. And that looks like a perfectly good excuse to book profits.