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Markets: Reinflating a bubble Add to ...

Governments around the world are angry with the U.S. Federal Reserve and its plan to pour hundreds of billions of dollars into the economy, devaluing the greenback in the process. But the move has investors believing that there is money to be made in stocks again.

Consider that stocks soared the day after the Fed's announcement last week that it would be buying about $100-billion (U.S.) worth of Treasuries each month through the middle of next year. The Wilshire 5000, the broadest measure of U.S. stocks, rose 1.9 per cent, gaining about $280-billion in value in a single day.

Who's buying? Sophisticated investors who understand how the Fed's quantitative easing will likely play out. They regard the commitment, which Fed chairman Ben Bernanke himself described as "a relatively unfamiliar tool of monetary policy," as the central bank putting a floor under stock prices.

The Fed is buying up top-grade bonds, leaving nothing for regular buyers such as pension funds to get their hands on, unless they can buy existing Treasuries. As a result, investors are forced into riskier assets, such as corporate bonds and stocks, which inflates the values of those investments.

The Fed believes that by buying up longer-term Treasuries, and thereby reducing longer-term interest rates, it will make housing more affordable and capital investment more appealing for businesses. Higher stock market valuations, meanwhile, will boost consumer wealth and should spur spending.

There's little doubt that the Fed is re-inflating an asset bubble in stocks and commodities, says Paul Vaillancourt, chief investment officer for Canadian Wealth Management, a Calgary-based boutique investment firm owned by Société Générale SA.

"They are delaying a problem," he says, but for the next couple of quarters, "we don't think there is any fear of bursting."

In fact, the Fed has created an opportunity that his firm cannot afford to ignore. Canadian Wealth Management does not try to time the market, but when Mr. Bernanke first announced late August that the Fed stood ready to provide extra monetary stimulus if needed, Mr. Vaillancourt began buying "at every opportunity," adding stocks from the materials sector and going overweight on Canada and emerging markets. He plans to begin adding holdings from the energy sector soon.

In the best scenario, the Fed's move will breath new life into the recovery, triggering the next economic cycle, without causing hyper inflation down the road. But the Fed can only create the right conditions, not actual jobs. It can't ensure that the new money flows where it wants. For instance, some major U.S. corporations are taking advantage of the stimulus to issue super-cheap debt. But they are using the funds to pay down older, more expensive debt rather than to build plants and hire more workers.

In addition to possible inflation, the Fed has greatly increased the risk of a global currency war with its latest stimulus move, because a side-effect is the devaluation of the U.S. dollar. This issue will be front and centre at the G20 summit in South Korea on Thursday and Friday. Part of the problem stems from the fact that the U.S. "wants to put the pedal to the metal" on economic growth, says Colin Cieszynski, an analyst with CMC Markets in Toronto. And that approach is at odds with Europe, where governments seem resigned to accept a new age of slower growth and fiscal austerity.

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