QE To Infinity?

"Boyle'sSelfFlowingFlask".
Licensed under Public domain via Wikimedia Commons 

Are we going to see quantitative easing (QE) to infinity?

Five and a half years on and QE has really got into the market's system. Indeed, the market is hooked on QE. Whether, the market could now survive without a regular QE fix depends on the economic recovery in the US. If the economy is robust enough the market's cold turkey period is likely to be less traumatic when it is weened off the Fed's QE program.

Since 2008 financial crisis central banks have been flooding the system with liquidity, keeping interest rates down to near zero level. The negative side effects of the medicine has been to create inadvertently huge asset bubbles, in real estate, equities, bonds, million dollar classic cars, billion dollar startups, a widening wealth gap and inflation of the price of necessities, such as food, energy, shelter etc. But every medication, or drug,regretfully has negative side effects. The question is whether it’s worked? Has loose monetary policy cured the patient; the strategy being to flood the system with money, with the aim of stimulating investments and consumption in the economy.

There are clear signs that US economy is moving in the right direction and outperforming all other developed economies (not a difficult task bearing in mind that most developed economies are experiencing stagnant growth). But has the US economy reached “escape velocity,” this is a fancy new macro-economic buzz word and in simple terms it means that an economy has grown at a sufficiently fast rate to escape a recession and return to a sustained economic recovery. With trillions of US dollars pumped into the system over a period of years the Dow Jones Index has rallied since 2008, but there has been no pyrotechnics in the real economy, growth continues to remain feeble.

Might it be premature then to wind down QE. Some participants are anticipating that the monetary authorities might stop Q3, albeit for a short period to test how the market responds. If we look back over the years, central banks did stop QI and then Q2. They may also stop Q3, only then to continue with Q4 at some later date.

If we look at an S&P 500 chart over the period 2009 to 2014 and compare it to daily net changes to Treasury Issuance, over the same time period. We notice that as the Fed increased the amount of Treasury Issuance the S&P 500 graph headed upwards. This pattern has occurred without fail over more than half a dozen times in the last five years, during the QE1, QE2 and QE3 periods. So there is a clear positive correlation between Treasury Issuance and the S&P 500.

The market increased nominally during this period, but it didn't increase in value. Why?

Well, every time the central banks pump the system with liquidity, the money supply is increased, which has had a depreciating effect on the currency, that is assuming the economy doesn't expand. If there are the same amount of goods and services in the economy and you increase the money supply, if that leads to an increase in demand, that will push prices upwards, given that there is no change in the amount of goods and services supplied. The outcome being that more money is needed to purchase the same amount of goods or services. That... is inflation. If the rate of inflation is higher than the S&P 500 increase then no real increase in value has occurred. Over the past few years food prices and energy prices have been rising steadily.

But what would happen when Q3 stops?

It might lead to a stagnation in the market for a period of time, the market could drift lower, it might even fall with more gusto, then maybe the music startsup again and we end up with more of the same ...Q4?

The eurozone will probably need their own version 2 or 3 of stimulus. But it could be slightly more complicated for the European Central Bank (ECB), particularly when they are entering the game at a later stage. The Bond market is already high, yields low. The bond market might be approaching the end of its bull cycle. So purchasing bonds at this late cycle would be like buying into a bubble and that could lead to losses if the bond market were to go into correction mode. Furthermore, not all sovereign bonds in the Euro zone are the same, the likelihood of defaults on sovereign bonds in the peripheral states is a real possibility. So QE in the eurozone is a little more complicated and risky compared to the US or UK.

Nevertheless, there is one drawback about QE that you cannot underplay, which is the risk of inflation. Former Fed Reserve Chairman Allan Greenspan said that he “would be surprised if there was a QE3 because it would continue the erosion of the dollar.”

Sure, the economics of that statement makes sense, but even the guy who ran the show got it wrong. It real does put egg on the faces of some City/Wall Street analysts, who were predicting a dollar crash. Today the US dollar is robust. Again text book economics and what happens in reality are often oceans apart, there are other opaque forces at work.

So is QE 4 on the horizon? What else can they do? When all you have in your tool kit is a hammer you treat every problem like a nail.