This is The End of QE: Part II, where we discuss the impact on various asset classes; What Does QE2′s End Means for Various Asset Classes? (Part I) appeared yesterday.
Yesterday, we looked at the reasons for the Fed’s policy of quantitative easing. This morning, I wanted to review what the impact of QE/ZIRP has been. From there, we can assess what its end might mean.
Its hard to understate the impact the Fed can have on asset classes. Recall Y2K — the Alan Greenspan’s unwarranted fears of a run on banks led the Fed to make a modest (~$50B) liquidity injection on October 22, 1999 — nearing the peak of the Dot Com mania. The Nasdaq DOUBLED over the next 6 months. The FRB isn’t responsible alone for that rise, but they certainly can take credit for a healthy chunk of it.
In March 2009, the S&P was down 55%, sentiment panic levels were at extremes, Valuations were fairly reasonable. Into this environment, the Fed launched a massive liquidity program designed to reliquify the frozen credit markets and recapitalize the financial sector.
You may be noticing a pattern: The Fed throws a lot of firepower at a problem, often when sentiment is at an extreme. What starts out as an extraordinary emergency situation morphs into ordinary policy. This is consistent with many Central Bank interventions over time. Not only are the bankers susceptible to the emotions of the crowd, they seem to ignore, surprisingly, Behavioral Economics.
Central Bankers appear to be ruled more by fear than logic.
Hence, our present situation. Following the implementation of ZIRP, QE1, and now QE2, it appears the political will for further intervention is fading. Opponents of the policy are no longer lone voices. QE2 is very likely to end without a QE3 right behind it.
The first impact of the end of QE/ZIRP will be a rise in the US Dollar versus a basket of currencies. Some people have pointed out that the Yen never suffered during Japan’s multi-decade ZIRP policy. But Japan is a major exporter, and buyers of Japanese good must buy Yen to purchase Japanese goods. Perhaps their trade surplus helps explain why the Yen has not been pressured as the dollar was.
The Fed liquidity bid under the market will disappear. That does not mean markets will head straight down; to the contrary, other factors — earnings, contrary sentiment, short squeezes, mutual fund inflows — have the potential to keep markets afloat longer than most everyone expects.
While many people are looking for an equity collapse post QE, I wabt to suggest we widen our focus, and consider the action in Bonds and Commodities post-QE:
• Bonds: The Fed has already bought $400B of their $600B in Bonds. When that bid goes away — or if the Fed begins to reduce their balance sheet and unload these holdings, what will that do to bond prices? We should expect to see a gradual rise in interest rates, with the 30 year climbing over 5% and the 10 year breaking out over 4.25%.
• Gold: Having little industrial value — its worth is what someone else is willing to pay for it — Gold may be the most vulnerable of commodities to the end of QE.Consider that the current secular bull market for gold began under Greenspan’s rate cutting regime back in 2001. His inflationary 1% Fed rates started the entire super cycle of commodities.
• Agricultural Commodities: Its not just the weak dollar. AG has currently run up on poor crops due to drought/floods, burgeoning Asian demand, and some speculation as well.
• Oil: The Middle East is the wild card, and it makes it difficult to assess what price action could occur if the Dollar strengthens. One thing is certain: The easy speculative money has already been made. Things become much more challenging for Oil traders.
While I do not discount the probability of a significant market correction — I figure 25% peak to trough when this bull has run its course — once the Fed’s liquidity begins to drain, other asset classes will be juts as affected as equities — if not more.
Part III will be published on Friday. It considers a) when the end of QE might be felt, b) different ways the cyclical equity bull market can end, and c) whether there will be a QE3 . . .