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.