The article was firstly published on May 23, 2012 on the Marketwise column of China Daily.
The Federal Reserve carried out three major unconventional monetary policies since late 2008, namely the two rounds of Quantitative Easing (QE1 and QE2) and Operation Twist (OT).
Instead of marking the Fed’s official announcement as the starting date of stimulating the national economy, I looked at the Fed’s asset size (i.e. reserve balance) to define the real start of the easing. For QE1, the Fed started the easing process when it bought billions of assets since September 2008, way before the official announcement in November 2008 and the program’s expansion in March 2009.
For QE2, Ben Bernanke, the Fed chairman, hinted at another round of easing in August 2010 at a conference in Jackson Hole (that was when the market expectation of QE2 materialized) and announced it officially in October 2010. For both QE1 and QE2, we saw a soaring reserve balance of the Fed (more liquidity provided to the market) during the term of QE.
For OT, which the Fed announced and launched it in September 2011, the overall reserve balance stayed flat as the Fed sterilized the additional purchases of long-term Treasuries at the expense of short-term bills and notes.
The first two QEs are different from OT in nature and hence had a different impact on asset prices. For QE1 and QE2, the Fed did throw billions of dollars to the market to inflate its own balance sheet and loaded up with securities. The overall capital injected to the market by the Fed can be observed by the increase in the reserve balance during the term of the two QEs. As a result, all risk assets including commodity and equity were buoyant with the increased liquidity. The effect on assets can be said as “too much money chasing too few goods.”
However, OT hasn’t expanded the Fed’s balance sheet as a result. Since OT is meant to increase the Fed’s holding in long-term Treasuries at the expense of the short-term ones, the overall liquidity in the market remained unchanged. With the extra purchases of long-term Treasuries, the Fed managed to keep long-term interest rates ultra-low.
Since the aggregate liquidity in the market has not increased, the impact of OT on asset prices is not because of “too much money chasing too few goods.” Instead, the magic trick that the Fed did in the past six months was to keep the risk-free rate, which is widely used to discount future cash flow in all equity valuation models, very low and in turn lifted the equity prices.
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| Source: Reuters, click to enlarge |
The Achilles’ heel of QE1 and QE2 was the effect of “too much money chasing too few goods”, which drove up not only equity prices but also commodity prices. The side effect of rising commodity prices passed through the supply chain of all businesses and caused margin compression for corporates, which at the end dragged down the equity valuations and prices. However, since OT doesn’t cause an increase in market liquidity, it has NO effect on commodity prices. This is the reason why we saw a strong equity rally (i.e. MSCI World Index) but a sideways commodity market (i.e. CRB index) in the past six months.
As OT will come to an end in June, I will go through the possible effects on the market next time.
