David Morris

RECENTLY, investors have got used to their expectations being met. Republican victories in the mid-terms led investors to expect a more business-friendly environment. The Fed’s latest QE announcement was in line with estimates, while a thumping gain in non-farm payrolls has raised hopes that unemployment may have turned a corner.

With the big set-piece announcements out of the way, investors are looking elsewhere for news. Sharp spikes in China’s producer and consumer prices have added to concerns that the Chinese authorities are ready to tighten. Meanwhile, problems in the Eurozone have re-emerged. With the Irish government guaranteeing its troubled banks, fears that Ireland will struggle to meet its financial commitments have seen its bond yields soar. This has led to renewed doubts over the ability of other weak Eurozone countries to handle their budget deficits and debt.

Given these worries, last week’s pull-back in equities looks modest. Investors must be putting their faith in the “virtuous circle” that Fed chairman Ben Bernanke wrote about: low rates boost stock prices; higher stock prices boost wealth; wealth boosts confidence; confidence boosts spending and spending boosts expansion. To this end, the central bank will be buying up $105bn of US Treasury debt between now and 9 December. Unlike QE1, the Fed’s firepower will concentrate on government bonds, rather than mortgage-backed securities.

The $600bn of QE2 means the US is less reliant on China to purchase its debt, but only in the short-term. The programme runs to the end of June 2011, which gives little time for the private sector to finish deleveraging and to stand ready to fill the gap left by the Fed.
In fact investors won’t want to go to the wire on this. By the end of the first quarter the Fed has to talk about reducing the size of its balance sheet, which will be a signal for everyone else to do the same. If not, then it’s QE3. And that will lead to an enormous backlash around the world.