10/5/2010
By David Urani, Research Analyst

On Monday October 4, Ben Bernanke all but assured us that the second round of quantitative easing, a.k.a. QE2, is on the way soon. Mr. Bernanke stated that he does in fact think QE2 has the ability to ease financial conditions. That comes after various other remarks from his colleagues at the Fed about further action being warranted. At this point, most everybody watching the market has pretty much come to the consensus that it will happen and stocks have already begun to trade accordingly. In fact, the market has been rallying on expectations for the Fed and other monetary actions for some time now, as we pointed out last week. Estimates for the amount of money we see poured into the banks point towards a range of roughly $500 billion to more than $1 trillion. As a reminder, QE in a nutshell consists of printing money, giving it to the banks through purchases of treasuries and other assets, which the banks in turn use to invest more freely than they otherwise would have. What ensues is increased lending, investing and price inflation.

The tsunami of cash headed towards the economy will have the market, once again, acting like it's drugged up on happy pills. Take the month of September, for instance, when a mix of QE2 anticipation and Permanent Open Market Operations (POMO) sent stocks virtually up in a straight line, even to the extent of ignoring lackluster economic news pointing to slowing growth and an economy that is teetering on the edge of a double-dip recession. Meanwhile, gold futures traded to a new record high every day like clockwork despite its obvious bubble characteristics, openly displaying the reservations investors have in the back of their minds during the best September rally in 71 years.

As you may remember, QE1 was instituted late in 2008 as the financial markets collapsed. Although stocks and commodities struggled at first, with the financial crisis still fresh, what ensued in early 2009 was the best six month market rally since 1933, which continued through the end of the year. The quantitative easing ended in March 2010, and soon after reality set back in. Oil and gold moved in similar fashion, with both roughly doubling since the start of QE, owing to the inflationary effect of having in a huge influx of new dollars. The dollar waffled between strength and weakness due to its relative strength versus other currencies.

S&P 500 – Circles indicate start and finish of QE. Source: ESignal

So, it seems increasingly likely that the market is going to continue in a delusional state as we wash the pain away with more funny money. Certainly at least part of QE2's (assumed) intention is to deface the dollar more, following global efforts by virtually everyone to weaken their respective currencies (see: China yuan peg, Bank of Japan yen intervention, among others). Exports are the name of the game, with that universally seen as one of the main potential boosts to employment and general economic growth. Consequentially, as we weigh on our dollar and spur inflation, prices of commodities will naturally be buoyed. On top of that, the rush to produce exports will spur the demand for commodities as raw materials, while hard assets such as gold will be seen as a hedge against inflation and waning faith in currencies. And finally, as a consequence of the anticipated inflation, the market, which is priced in dollars, will see upward pressure as well.

Remember though, any optimism you are seeing already, and are likely to see in the months ahead, is stock market Prozac. The main reason QE2 is on the way is to avoid a double-dip recession and while QE can help to improve consumer confidence through lending and a more buoyant stock market, the poor fundamentals in the economy are still in place. When it comes to real-life dangers like a second recession in housing or a slowing manufacturing sector, QE can help to skirt a disaster but it will by no means avert it outright.

David Urani
Wall Street Strategies

Add a Comment!