Quantitative Easing and the Markets
It is hardly surprising that the members of the Federal Reserve Open Market Committee, the policy making body of the central bank, discussed the state of the economy and the impact of their policies, particularly the most controversial quantitative easing, at their January meeting.
It is a measure of the enormous sensitivity in the markets to Fed policy that the observation in the minutes from several board members, that quantitative easing may have to end or be curtailed before the stated Fed goal of 6.5% unemployment is reached, sent trading markets into a tailspin.
The Dow lost about 90 points after the release of the minutes, closing down 108.13, 0.77% at 13.927.50. The S&P lost 19.02 points, 1.24% to 1,511.92 and the Nasdaq shed 1.53%, 49.19 points to 3.164.41, the bulk of the damage occurring after the 2:00 pm release. The dollar was the one beneficiary gaining 0.5% against the euro after the release but 1.2% on the day. Spot Gold dropped 2.54%, $40.80 to $1,563.34, its lowest point since last July. WTI sank 2.30% on the Nymex Exchange, closing down $2.23 to $94.46
The Fed is currently committed to buying $40 billion a month of mortgage backed paper and $45 billion of Treasury securities in open ended support of the economy. The sensitivity of the FOMC to the risks of quantitative easing does seem to be rising. This is the second set of minutes to include comments on the possible end of special liquidity provisions.
If the Fed wanted to prepare the markets and the economy for the end of quantitative easing this how the committee and the editors of the minutes would begin.
For the equity and commodity markets quantitative easing has meant artificial price buoyancy. Market participants, shorn of most other opportunities for investing their funds by the zero rate policy of the Fed, have pursued the averages higher, certain that most other participants would do exactly the same. The US economy may have improved recently but it is very doubtful that its health warrants a Dow average that until today was within 100 points of its all-time high or a $98 price for a barrel of oil.
In the currency markets where the vast majority of trading takes place against the dollar, quantitative easing has meant a permanent bias against the U.S. currency, an undercurrent that surfaces whenever the European debt crisis has gone on hiatus.
The deliberate Fed policy of using liquidity to bolster the wealth effect of higher equity prices on the general economy may have run its logical course. If most market participants accept that price levels are artificial then the chance that this will prompt other economic activity is small. Businesses will want to see how the economy performs when the liquidity and rate support is withdrawn before they expand their operations.
The extreme sensitivity of traders to the potential end of Fed liquidity is a sign, and perhaps an unwelcome sign that the strength of the equity averages is founded on little more than a search for return in a zero rate world.
Is the Fed signaling that the time is coming for the economy to stand or fall on its own?