QE2: one is not amused by the potential for US equity downturn

THE sheer size of the numbers involved in the Federal Reserve’s quantitative easing program (QE2) can be difficult to comprehend. By comparison, Queen Elizabeth II receives a paltry £7.9m per annum from the Civil List. This is nothing compared to the $600bn of US Treasuries bought by the Federal Reserve during this cycle of quantitative easing – which is enough to build 888.4 RMS QE2 ocean liners (adjusted for inflation).

The massive printing of money by the Fed in order to fund this unprecedented scale of purchases of Treasuries has had a huge effect on the US currency. But it has also had an inevitable effect on equity markets.

Her Majesty was unavailable for tips on how CFD traders should position themselves leading up to the expected end of QE2 (but according to palace insiders, she is unsurprisingly tipping Carlton House for the Derby).

In the absence of royal authority, Michael Hewson, the king of CMC Markets’s market analysis said “the money has to go somewhere, and it has pushed equity markets higher. The next week will be key for the future of the Fed’s quantitative easing plans. First quarter GDP is set to be released, and further deterioration of economic data will increase the pressure on the Fed to embark on QE3.”

LIQUIDITY VERSUS MONEY SUPPLY

Since the beginning of the Fed’s quantitative easing program, the US central bank has tripled the amount of liquidity that it had made available. However this marathon monetary print-run has not resulted in a corresponding tripling of the money supply.

The graph right comes from a report by Richard Koo, chief economist at Nomura Research Institute. It shows the US monetary base along with the money supply and outstanding bank loans and leases. It shows the sharp diversion of these three indicators following the 2008 financial crisis and the ensuing money printing. Since then, liquidity has hit nearly 300, but the money supply remains at 115.

In the fallout from the Lehman Brothers implosion, businesses moved to deleverage, meaning that investors were unable to increase their holdings of private sector debt. With the increase in T-bills being bought up by the Fed, funds were instead directed towards equities and commodities.

So how should traders position themselves as the second round of QE comes to a close? According to Manoj Ladwa, senior trader at ETX Capital: “I think the deflation in equity prices is already underway. By pumping more money into the US economy, the Fed effectively brought rates down to sub-zero levels. QE had the effect of pushing money into equities and commodities as money in a bank account was earning nothing. But closing down QE and with corporate earnings having potentially peaked, there is little upside left for stocks.”