Funds have been flowing into equities and other risk assets in the hope the US Federal Reserve will go in for another round of quantitative easing (QE), the technical term for the central bank buying bonds from the banks.
The first round of quantitative easing helped the banks to regain confidence, but didn’t do much for the broader economy. That’s because while the central bank can put money into the hands of banks by buying their bonds, that may not lead to more lending simply because there isn’t demand for credit. This time too, while more of the same medicine may not do wonders for the US economy, it will reduce interest rates and that will lead to a search for yield, with emerging markets bearing the brunt of the inflows.
But how much of the new round of quantitative easing is already discounted? A Goldman Sachs report points out that, “financial conditions have eased substantially due to movements in all four components: lower ten-year treasury yields, lower short-term rates, higher equity prices, and a weaker dollar. The lessons of QE1 have thus been mirrored in the anticipation of QE2.” It believes, however, that equity prices have risen less than the experience with QE1 would suggest. Its conclusion: “Finally, the experience of QE1 is that the impact on assets tended to grow over time, even some time after the announcement. This suggests that even after the moves seen to date, these trends could extend in some places. Consistent with this conclusion, our market group expects more dollar weakness and moderately more S&P upside.”
Graphic: Ahmed Raza Khan/Mint
Equities have rallied since the report came out about a week ago, but there could be several caveats to the optimistic view. One is the obvious one that equity valuations today are much higher than when the first round of QE took place last year.
Another is that much depends on the amount of bonds the Fed will buy—Goldman Sachs estimates that about $1 trillion worth of QE2 is already priced into equities.
Any suggestion that the Fed is dragging its feet could therefore lead to a sell-off—at least until the market starts speculating on the next round. Ben Bernanke’s speech on Friday could give important clues about the Fed’s thinking.
But if the US dollar is any indicator, then perhaps there’s still some more room for risk assets to rise.
The dollar index, which measures its performance against six major currencies, has fallen sharply since the hopes of a second round of monetary easing flared up. It has fallen from around 88.3 in early June to around 77.3 now, but it’s still above the lows of 74.3 or so it reached in early December last year.
And since emerging market equities and the US dollar are inversely correlated, there could be some juice left in the rally. But everything depends on the Fed opening the floodgates of liquidity.