Bernanke says Low Rates, Markets Agree:

Even though Quantititave Easing II (QE2) officially ends today, small cap investors should look for much of the same from the Federal Reserve under Ben Bernanke with top gainers such as Alanco Technologies (NASDAQ: ALAN), China Distance Education (NYSE: DL), (NASDAQ: CHCI), and LiveDeal (NASDAQ: LIVE) enjoying the liquidity pumped into the financial markets.

As his press conference in April, Bernanke stated that the Federal Reserve was commited to a low interest rate environment. This obviously entails that the United States is able to sell Treasury bonds easily to underwrite the Federal budget decifit. As QE2 entailed the Federal Reserve buying about $70 billion a month in Treasuries, about 70 percent of the total, the questions naturally beckons of who now will step in with QE2.

The answer: the Federal Reserve. As a result of the expansion of its balance sheet from bailing out the financial sector during The Great Recession, the Federal Reserve now has about $3 trillion in assets. This is well over $2.3 trillion more than it had in 2007. Much of it is in "toxic assets" from Fannie Mae, Freddie Mac and other instutions. Obviously, these assets cannot sit on the balance sheet foreover as there are no appropriated funds from Congress backing them. The purchases were the result of bookkeeping transactions with the Federal Reserve and its regional banks, not the Federal budget process.

The price of toxic assets has risen. This has transpired due to several factors. Wall Street naturally overreacted and drove down the prices of mortgage backed securities too much. A rebound has naturally occurred. In addition, with interest rates so low the yields on these instruments now makes them very attractive. By keeping interest rates low, the Federal Reserve increases the value of the toxic assets on its balance sheet, making a sizeable profit: nice work if you can get it as "the house always wins."

By selling off the toxic and assets and letting other bonds mature and reinvesting the proceeds, the Federal Reserve can continue to underwrite the United States budget deficit and keep interest rates low. QE2 required about $70 billion monthly in Treasury bond purchases by the Federal Reserve. With $3 trilion on its books and an investor community hungry for high yields, the Fedeal Reserve can sell off its holdings at a profit to finance the purchase of Treasuries. This is a balancing act, for sure: if the Fed sells too many securities and removes too much liquidity from the banking system, interest rates will rise. It is working so far as since the ending of QE2 was announced, rates have not risen. There are political considerations too: QE2 did not commence until after the November 2010 elections. With a presidential election coming in November 2012, small cap investors can bet that the Federal Reserve will keep rates low until at least 2013.