HAS THE MARKET PRICED IN QE ALREADY?
The market has soared in recent weeks as deflation fears and double dip recession fears have been erased by better than expected economic data and an overwhelming confidence in the Federal Reserve’s ability to generate inflation and a sustained economic recovery via quantitative easing. But as the rally advances Goldman Sachs ask an important question – has the market already priced in QE2? Goldman’s analyst’s have put together a useful analysis that succinctly summarizes the expected impacts of QE2. Figure 1 shows their expected results due a second round of QE. They explain the assets and expected price movement based on $1T of further QE:
“First, the basic pattern of market moves is broadly consistent with growing anticipation of additional QE. The middle part of the table shows the actual change in the GSFCI components and the 10Y Treasury yield since early August. We see that financial conditions have eased substantially due to movements in all four components: lower ten-year Treasury yields, lower short-term rates, higher equity prices, and a weaker dollar. The lessons of QE1 have thus been mirrored in the anticipation of QE2.”
According to Goldman, QE2 has already been priced into treasuries and the dollar, however, equities have not responded to the same magnitude:
“Second, while guessing the magnitudes is hard, the size of these asset price moves suggests that markets have moved quite far toward pricing the kind of program we expect. In particular, a purchase program of about $1tr may now be reflected in 10-year Treasury yields, the three-month Libor rate and the dollar. Spreads—defined here as the difference between the synthetic long-term yield in the GSFCI and the yield on ten-year Treasuries—have contracted less than suggested by the first round of purchases, at least so far. (This might not be surprising given that spreads are much narrower going into the second round of purchases than the first.) Similarly, equity prices have risen less than the experience with QE1 would suggest. This finding, however, is sensitive to when we think the market started pricing in QE2; equity price gains since Bernanke’s Jackson Hole speech have been more pronounced.
The view that the market has at least gone some way towards pricing in QE2 is consistent with a recent poll conducted by our fixed income sales team. This survey polled 59 clients to find that 50% of participants expect more quantitative easing with an average amount (over all participants) of $500bn. (This survey was conducted on September 21 prior to the last FOMC meeting and the recent speeches by Fed Presidents Dudley and Evans, both of which signaled a high likelihood of QE2 as early as November. One would expect that participants’ expectations have risen in response to these events.)
Finally, the experience of QE1 is that the impact on assets tended to grow over time, even some time after the announcement. This suggests that even after the moves seen to date, these trends could extend in some places. Consistent with this conclusion, our market group expects more dollar weakness and moderately more S&P upside.”
Figure 1
Randall Forsyth at Barrons, however, says the equity markets have already priced in the move that Goldman expects in equities:
“SINCE BERNANKE STARTED laying out the rationale for further easing in his speech at the Fed’s annual bash in Jackson Hole, Wyo., in late August, the U.S. Dollar Index has declined roughly 7% against that basket. Over the past six weeks, gold is up more than $100 an ounce, topping $1360 as the Fed and other central banks engage in their race to debasement.
During that same span, the Wilshire 5000 has gained about $1.3 trillion in value, or about 9.9%. But the rise in stocks may be more apparent than real.”
Quantifying how much of the recent rally in equities is due to QE is practically impossible, however, one thing is clear – the prospects of global intervention began on September 15th when the BOJ intervened in the markets. If you recall, the equity rally began when the August ISM report surprised substantially to the upside and quelled fears of a double dip. The dollar declined that day as deflation fears were replaced by inflation fears and treasury yields rose in tandem. The market did NOT rally because of QE. The dollar decline did not begin in earnest however, until almost two weeks later when the BOJ intervened in the Yen. The potential for a currency war and multiple central bank’s intervening in global affairs lit the fire under the “QE2 rally” and subsequently tanked the dollar.
It is this dramatic dollar decline that is causing the melt-up across the board as every asset surges on the prospects of a devalued dollar and a world awash in liquidity. This is most interesting when viewed from relative terms, however. The dollar’s decline in most other currencies shows that FX traders view the US economy as being the worst house in a bad neighborhood. The bond market appears to be in agreement here as yields shoot lower and forecast an economic environment similar to Japan’s lost decades. This shouldn’t come as a big surprise to anyone. In my opinion the bond market is merely reflecting the Fed’s pessimistic view that interest rates need to remain low for an extended period. After all, the Fed wouldn’t be proposing a second round of QE if it hadn’t seen the data and didn’t already know that it was necessary to provide further padding under the weak U.S. economy.
The odd man out here of course, is the equity market. It’s clear, in retrospect, that the extreme deflation and double dip fears were exaggerated in August. I knew something was terribly wrong when every newspaper in the country was discussing the prospects of an environment I had long been in the minority of believing – the Japanese deflationary scenario. But like that, someone flipped a switch and deflation, just 6 weeks later, is a thing of the past and the new new thing is worrying about inflation and the Fed’s ability to spark inflation via QE2 (even though QE adds no net new financial assets to the private sector and therefore has no inflationary effect).
The FX and bond markets are now projecting an environment of U.S. economic weakness, which I largely agree with. The equity markets, however, are forecasting a period of sustained recovery and inflation. One of the these markets is wrong.
Figure 2
I think the equity market will ultimately be disappointed to realize that QE has no inflationary impact on the markets. I’ll say this again because it is important – QE does not add net new financial assets to the private sector. It is incorrect to view this expansion in the monetary base as inflationary. It is merely an asset swap. The dollar is currently pricing in what I believe is an overly optimistic outcome in terms of inflation. The markets believe QE will add liquidity and result in inflation (despite substantial evidence to the contrary). David Rosenberg has described this as the “liquidity spigot”:
“It’s all about the dollar. When it goes down, the liquidity spigots gets turned on. When it rallies, it’s a sign of a flight-to-safety. Let’s just say that we could well be in for a big short squeeze here on the U.S. dollar. According to the latest Commitment of Traders, the net speculative long position on euros is at 27,451 contracts (125,000 euros), which is a huge swing from the mid-May net short position of 105,145 contracts and the most that the non-commercial accounts have been long the euro since the week of November 10th, 2009. What happened back then? Well, the euro went from 1.50 to 1.47 a month later, 1.45 two months later and 1.37 three months later.”
If we use Goldman’s analysis above it is clear that the dollar has more than priced in QE and what the market incorrectly views as its inflationary impacts. In sum, the equity markets corrected higher in early September due to excessively deflationist outlooks and have been further supported by the dollar decline. The dollar currently appears to be pricing in QE of more than $1T. In addition, the dollar appears to be confirming the bond market’s outlook of a continued weak economic outlook. If we use my Dollar quadrant chart as a guide we can see that the most recent rally is likely further signs of a “fake” bull market:
Figure 3
If the economy remains weak as the bond market and FX markets are currently forecasting while also misrepresenting the likelihood of higher inflation then we’re likely to revert from quadrant 3 closer to quadrant 2. If the dollar readjusts in the coming months it will serve as a substantial equity market headwind. What the dollar giveth, it is likely to taketh away.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
Follow Me:
44 Comments
TPC
In the body of your article, you say ” I knew something was terribly wrong when every newspaper in the country was discussing the prospects of an environment I had long been in the minority of believing – the Japanese deflationary scenario.”
But, I have read articles you have written indicating that you think our condition is very similar to Japan.
Could you clarify your thoughts ?
Mike
The two statements are not inconsistent: TPC is saying he believes we are facing a Japanese like environment, but thought something was wrong when a bunch of mainstream newspaper started publishing the same type of believes / stories. Once the main street picks on on such a story it is likely to be over-anticipated, but does not shake his longer-term believe of such similar outcome.
Correct.
If we are not in a double dip, then why does the Fed want more QE? And why do you think August ISM for manufacturing, which was a weird outlier number and not confirmed by concurrent or subsequent date ( see September ISM, for example) is indicative of a no double dip scenario?
I think equities are very wrong, but I also understand that they may be responding to a flood of new FRNs.
By the way, QE2 was first floated in earnest in July, right when market bottomed
Bruce,
You may have missed the Chris Whalen article about how terribly bad shape the banks are in, and that he expects several ( BAC and Wells being the worst) to face failure in the next 3-6 months. As stated in that article, it is likely that Bernanke is even closer to this potential disaster and will need to use QE2 as a means to try and somewhat stabilize the system. Neither TPC nor most of the readers here believe that QE2 will do anything to help that situation, but try and explain that to Bernanke.
TPC,
I have asked this before, but it was in an old thread: Could you please elaborate why QE does not put money in the hands of banks, which then looks for a home in HY or equities for example? Are the reserves not dollars that can be spent? Is there some technical reason for that?
It’s just an asset swap. QE doesn’t change the amount of dollars in the system. There was nothing stopping any of these banks from buying other assets before QE.
Of course it changes the amount of dollar in the system, FED put newly printed $$$ into the system.
Your view is a static view and very wrong, you completely ignore the fact that dynamics change the price level, not static accounting.
Are you implying that the Fed is going to buy treasuries for well above their market rate? That is ludicrous. The will not do such a thing. While this would certainly add net new financial assets as TPC likes to say, there is no chance that they will buy at a huge premium and there is little chance that doing so would have an enormous impact.
Talking about whether stock market has priced in QEII is foolish, the fact is nobody knows. There are 2 factors that will determine which way market will go: 1) liquidity (we have more than plenty) 2) earnings (continue to beat), give me a reason why stock market can go down please!
I have been bearish for years, but now I see absolutely no reason to be bearish on equity in the shorter term. All eyes should be on China and other emerging markets, if inflation becomes unbearable, then another leg down is near.
It’s a “win win” right?
Good analysis – it does seem we are on the cusp to move to your quadrant 3. I would elaborate on your oft-presented point that “QE does not add net new financial assets to the private sector. It is incorrect to view this expansion in the monetary base as inflationary. It is merely an asset swap.”: Owners of (essentially) zero yielding bonds are mostly indifferent between them and what the FED gives for them… zero yielding cash. If any individual owner of zero yielding bonds had a strong desire to exchange those for positions in equities he can readily sell the bonds and invest in equities regardless of the FEDs actions. Swapping low yielding bonds for zero yielding cash because the FED encourages it with a new round of QE does NOT imply that there is suddenly new demand for equities. The idea that a large quantity of zero yielding cash “burns a larger hole” in the pockets of investors than a large quantity of zero yielding bonds really does not follow.
Hmmm, ~2.5% yielding bonds with close to zero financing from the Fed is THE TRADE in banks – almost risk free arbitrage i n large amounts with which to earn the current hidden losses over time. So it is not swapping zero yield for zero yield.
not according to jeff the bull saut!!!! he has the typical data mining in his weekly bull missive. plus jeff says it’s good for M+A good for US exports, good for housinjg etc. jeff says fund managers must play catch up here to collect their bonuses. jeff’s models all turned bullish at the low. jeff says the market is a little overbought but the upmove is powerful so it may stay overbought. all cheers to jeff.
Saut make so many often verbose contradictory predictions that one has to stick.
Saut clearly doesn’t spend his extra time trying to understand the monetary system. He is making the same mistake that most people believe – the QE is “printing new money”.
Greenspan himself admits QE has limited effect in this environment:
http://www.youtube.com/watch?v=wdesRuU3R2c&t=09m22s
9:22 in.
I’m struggling to understand the reasoning behind a QE2. At best, it does little to spur lending or borrowing or increase the velocity in our economy. Low rates are only good when borrower’s in need are credit worthy and when savers are full – neither exist in this case.
The other side of QE2 is nasty. Higher commodity prices (bad inflation) and lower rates which are hurting retirees and savers – news out today no increase in COLA for S.S. The consensus is also missing the fact that banks are getting squeezed as INT/LT rates come down and their interest margin (NIMs) drops significantly.
Once again, it seems that the policies being proposed and implemented are focused solely on a short-term fix and to the benefit of the corporations and the affluent. The other 98% of the US population is getting squeezed by higher prices, stagnant wages and terrible prospects in terms of return on savings. Can’t see this ending well.
Great insights!
CNBC’s article today says it all – Fed Certain to Act in November In a Big Way: Survey.
“Nearly 93 percent of the 70 respondents, including economists, fund managers and traders, believe the Fed will boost the size of its portfolio, up from 69 percent in the survey two weeks ago.
Of those who expect the Fed to move, 86 percent look for an announcement in November, up from 38 percent in the last survey. ”
This points to a contrarian outcome…
you say no effect only an asset swap. But what if the assets purchased by the fed are not worth what they pay from them. Lets say they buy a trillion dollars of MBS which are only worth 800 billion. They have in effect again bailed out the banks, That is what this is really all about, it is a continuation of the under the covers bailout of the too big to fail banks. The fed started by buying 1.25 trillion of MBS and now they are finding the banks are still in trouble. They stopped mark to market so the banks don’t have to reveal the true extent of their bad positions and now the fed can bail them out by buying this crap for par. All of the other noise about interest rates and a bad economy is just a diversion. All of this while they claim TARP was huge success. The american taxpayer is being sold down the river again. We need to wake up and end the fed.
The market thinks QE is inflationary. Just look at the rally. If this is all so great for the banks then why haven’t the banks participated AT ALL in this rally? The big rally has occurred in inflation hedges. QE is not inflationary.
So QE is deflationary? How? I’m afraid your view is very wrong. I wish I could do an experiment like I do with science to show what will happen, but, anyway, we’ll see.
Have you read this? I have already discussed all of this and explained in great detail why QE is not inflationary.
http://www.hoisingtonmgt.com/pdf/HIM2010Q2NP.pdf
….so has the Fed, so has the BIS….why does the market still think it is? I can understand the stereo effect of cynacism about what these official agencies say and the screeching from the likes of the gold bugs and CNBC’s of the world poisoning views on this subject, but really, just think about it….
As per Jake Wood above, I agree the first part of the ‘credit easing’ did have a bailout nature, but now they’re talking real QE, which is clearly different, but which is irrelevant at the end of the day. Weren’t teh Fed’s own f/c about +0.3% of GDP per trillion?
And TPC is right (a couple od msgs down) where he says banks would rather hold Tsys. Look at the Fed data on bank Tsy holdings vs C&I loans, for example…..a massive turnaround.
It’s already been proven that the recent 11% stock market rally was offset by an equal move in a basket of commodity prices. So, all the gov’t policies are doing is lowering the value of the dollar and punishing us savers.
QE didn’t cause the majority of this rally. The rally was caused by a rejection of the double dip notion. Just look at when the rally started. As TPC mentioned, it started with the ISM report. Better than expected data sparked the rally and QE has just been the latest excuse for herding the sheep to the slaughter.
the issue what does the fed buy? at this point the market is assuming the fed buys more treasuries. I’m saying they will buy more of the banks overvalued assets. The banks will go up once the market sees what they are going to buy. It isn’t about inflation, that is just a cover story to justify their actions. Its a bank bailout, just like the the first 1.25 trillion of MBS was a bank bailout. The fed will do whatever they have to do to save the big banks. The rest of it is just noise.
They’ve already said they would buy tsys this time around. They’re not worried about interest rates in the credit markets because the credit markets aren’t clogged.
How is it a bank bailout this time if they’re just buying tsys? I think the banks would prefer to hold tsys at this point in time.
You have to ask yourself why the banks aren’t rallying if this is your thesis?
You are repeating yourself and ignoring my point. Apparently you don’t want to hear anything but your own view of things. They are not committed to just buy treasuries, that is just the current assumption. We can agree that it is not a bailout of banks if all they buy is treasuries.
My point is that you are missing the real agenda, which is to bailout the banks. You may not agree but at least acknowledge the point. The fed is going to buy the junk assets off the bank balance sheets. They have already started the process with their previous purchases of MBS. Congress lacks the will to set up a resolutin authority to clean up this mess, therefor the only other way to do it is for the fed to buy the crap.
He has already said QE1 was a form of a bank bailout. You are the one who isn’t listening.
It doesn’t matter if the Fed buys MBS or treasuries this time. Neither one will help the real economy. That is the lesson from QE1. What do you not understand about that?
As TPC said, it doesn’t matter if we fix the banks again. They’re not the cause of the problems. They’re just a symptom.
Try reading the articles rather than just arguing.
TPC: Your quadrant analysis is correct and insightfull
A question every Trader/Investor should ask every Day/Week/Month
How should I position my funds based on the Quadrant.
Maybe other posters could add to your list–you being the judge?
How many up/down 40% moves in Nikkei since 1989?
the market has priced in something that has not happened and will not help if it does happen.
the very definition of irrational.
“The dollar’s decline in most other currencies shows that FX traders view the US economy as being the worst house in a bad neighborhood.”
Detroit crack house, here we come!
Lord, I hope not.
We’ve got to get people back to work soon, before they get used to not working. Nothing is worse than that.
You often mention that QE is an asset swap.
The Fed has a trillion or so in reserves available to swap.
Do you contend that the size of their QE2 program is limited to available reserves?
If not (i.e. QE2 exceeds the reserves), then what Fed asset is being swapped for the Treasuries?
Where does the Fed get the money? Where does our govt always get the money from? Nowhere. They just change numbers in accounts. In this case, they add to the monetary base, but don’t actually add net new financial assets to the private sector.
Read the section enclosed about the monetary base:
http://www.hoisingtonmgt.com/pdf/HIM2010Q2NP.pdf
I am familiar with the monetary base, M0-1-2-3, thanks.
There are a few issues with Hoisington and the Fed’s terms (see below), but that’s beside the point.
I asked, in the event POMO exceeds current reserves, what asset is the Fed swapping?
You responded: “Where does our govt always get the money from? Nowhere.”
So which is it? Is the Fed swapping a preexisting balance sheet asset for securities via POMO? Or, as you stated, in this hypothetical case are they swapping nothing (an asset newly created from thin air) for something?
—
Minor notes re. monetary base and Mx definitions:
VanH says “The monetary base, bank reserves plus
currency, does not fulfill these functions and hence
does not constitute money.”
That’s pretty sloppy, b/c later they state “Federal Reserve calls the stock of money represented
mainly by currency and checkable deposits M1″.
So clearly there is significant overlap (currency in circ) between the two.
And there are some distinctions without a difference:
M2 includes “money-market mutual funds”.
M3 includes “money market mutual fund shares held by institutions”
Situation: my wealthy client sets up a large irrevocable trust with (the same) assets formerly held in a margin account.
Did M2 just fall while M3 remained constant?
Why are we tracking M2 but not M3 in this instance?
VanHoisington is not the ultimate authority on these matters.
TPC has explained this 100 times.
The governmentt has no “pre-existing” money. They don’t just have piles of money sitting around that they use for various projects. When they want to spend money they walk into a room and type numbers into a computer. They don’t call China first and they don’t see how much you paid in taxes last year.
Where does the Fed get the money from? They get it from nowhere. They create it out of thin air. The Fed’s side of the balance sheet is merely accounting. Their side of the ledger doesn’t mean there is now twice as much money in the economy. When the Fed decides to buy tsys from the banks they essentially credit their own account and then buy the tsys. It’s an asset swap. The bank are credited with cash and the Fed’s balance sheet shows a tsy security that replaced the cash.
The disagreement here is about terminology.
For most anyone not in the financial industry, an “asset swap” is a pretty obvious thing, e.g. tangible for tangible, or tangible for a financial instrument.
But in this discusssion, it appeared TPC was playing inside baseball, using “asset swap” to indicate an interest rate swap
http://www.yieldcurve.com/Mktresearch/LearningCurve/LearningCurve4.pdf
But POMO is an outright purchase. It’s not just an agreement to swap floating for fixed for a period of time.
Whether using this standard financial definition or the lay understanding of “asset swap”, QE is neither.
In an August 9 2010 post, TPC noted
“JJ Lando a bond trader at Goldman Sachs has eloquently described QE:
“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”
Lando says “converts overnight reserves”.
This circles back to my original question- essentially, can the Fed do QE for a larger amount
than their reserves? Lando implies “no”.
To clarify my position:
I agree with Goldman’s analysis, and TPC’s too in his original post above. And I like the conceptual framework behind the quadrants.
We just haven’t come to terms on “asset swap” usage.
An asset swap. A trade. What do you not understand about that? The banks get cash the Fed gets their treasuries. It’s pretty simple really.
At the end of the day we need real economic growth. We don’t have it and QE will not generate it.
The market thinks QE is inflationary.
If the market thought that QE was inflationary, then the 10-year wouldn’t be under 2.4%.
The market appears to think that QE is good for corporate earnings. That may make some sense, if you believe that (a) QE will result in more business lending and (b) businesses will pull up demand, rather than lag consumption.
Personally, I see QE2 as a sign that the Fed is switching to a supply-side-driven strategy. Since the Congress refuses to stimulate and feed aggregate demand, supply-driven demand is all that is left. Fortunately, businesses have enough cash that they can afford to expand, if they choose to take the plunge.
Business investment is the largest missing component of the recovery. While government spending hasn’t grown any faster than it normally does (forget the right-wing political media hype; GDP numbers show that overall government spending growth isn’t there) and consumption has essentially flattened out (in absolute dollar terms, it now exceeds pre-recession levels), business investment is still well below peak.
With business spending now equal to about 2003-4 levels, there is potential for upside there. The question is whether that spending increases in response to QE or for whatever other reason. If it does, then stocks may be on the cheap side, but still no bargain; the upside is limited, even with reduced unemployment and a recovering consumer. If it doesn’t, then equities are probably a bit overpriced, but not terribly so; the world isn’t ending, and the market doesn’t seem inclined to sell off substantially. I suspect that we’re just in a trading range, and the market doesn’t have that much further to go, i.e. <10% up.
The near-complete divergence among bonds, equity and commodities is disconcerting, and that is due to a correction. The logic usually favors the bond side, but this time may prove to be an exception.
Reason business investment is flat busted is simple: lack of demand (consumers who are busted flat in debt), that is the FOREMOST reason offered in why businesses refused the latest credit deal from Obama. “I don’t need a loan – I need DEMAND to pick UP!”
Agreed. However, the recession began almost three years ago and the Lehman failure was just over two years ago. Credit is quite cheap and consumption has bottomed, so there may now be at least some businesses that may choose to borrow cash and expand in anticipation of future demand. It may just be a matter of timing, as much as anything else.
Speaking anecdotally, my own business banker is trying to throw credit at me that I don’t particularly want or need. When I made it clear that I didn’t need it, the banker’s response was to pitch me about an unsecured line that didn’t require a personal guaranty. That wouldn’t have been available to folks like me a year or two ago, and while I’m not personally jumping at the offer, you know that at least some others will.
Until we perform redress to the HH debt situ (debt destruction & deleveraging), we are toast.
While that would optimal, that isn’t critical. Debt can be recast and modified to achieve some of the same effect, at least for the purposes of getting through this business cycle.
Warren G Harding’s words could never be more appropriate than now.
Dude got us out of the “DEEPEST DEPRESSION” of all time. Check out DiLorenzo’s write-up of him under Wiki.
You may not be such a “right-winger” hater after that.
Don’t fall for the revisionism, and follow the timeline. The Depression began in 1920; Harding didn’t enter office until March 1921.
Prior to Harding taking office, the Fed had been raising interest rates, when they should have been cutting them. The Fed reversed course not long after Harding came into office, and the depression ended just a few months after he took office.
Harding’s tax cuts took effect after the Depression had ended and his death. He hadn’t been in office long enough to earn credit for resolving the depression, an event that was tapering off as he entered office.
The Fed was a new institution at the time, and just really blew it. Imagine what would have happened had Bernanke responded to the Lehman crisis by cranking up interest rates, and you’ll have an idea of what was going on during 1920.