Will Quantitative Easing Save the Equity Markets?

by Erico Matias Tavares

“In times of crisis, organizations tend to repeat their actions, but with more vigor and frequency”

An aphorism from the author’s Organizational

Science course in grad school

2 October 2010

Notwithstanding persistent headwinds in the global economy, ranging from sovereign debt fears in
Europe to double dip risks in the US, equity markets had their best September in over seventy years.
This may be largely attributed to the expectation that in order to prop up a flagging recovery the US
Federal Reserve will soon embark upon a second quantitative easing (QE) program, as further
evidenced by recent US dollar weakness and gold reaching historical highs (in nominal terms).

This expectation seems to be getting traction. According to a leading financial blog (1), Goldman
Sachs recently sent a note to its clients stating that the Fed will announce $500 billion in asset
purchases at the November 2-3 meeting. Even prominent hedge fund managers are publicly
proclaiming that QE is a sure thing, and that this will put a floor under equity prices.

But will the Fed implement a sizeable QE program over the near-term? And how much is actually
needed to keep equity markets humming along?

Some Historical Perspective

We developed a proprietary liquidity indicator which is based on how money is actually created in a
modern economy.

Comparing the year-on-year evolution of this metric relative to the S&P 500 provides some
interesting insights, as shown in Graph 1. The selected period covers the two major bear markets
which occurred over the last decade.

Liquidity growth typically slows considerably as the S&P 500 goes into a bear phase, and surges just
before its end – primarily due to the Fed’s intervention. Coincidentally (or not), the current gold bull
run started around the first time the Fed embarked upon this process in the early 2000s.

The period leading to the crash of 2008, however, had some very distinctive features. Liquidity
growth started declining precipitously after March 2008, reaching negative values around November.
This was the only time negative growth was recorded in our series, which goes back to the early
1990s. To put this in perspective, in mathematical terms the index needs to grow at least by the
“average” interest rate of the economy, otherwise an increasing number of borrowers will start
defaulting on their interest payments (let alone amortize their loans). A negative print is thus a severe
event, leading to a downright contraction in the economy.

The Fed responded by implementing unprecedented monetary policy actions around October 2008.
The liquidity growth index then turned positive and started to consolidate upwards around March

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2009 – the bottom of the bear market. Equity markets soon followed suit, clocking up substantial
gains in a relatively short period of time.

Graph 1: Weekly S&P 500 and Liquidity Year-on-Year Growth – Jan 1998 to Present

1800 20%

1600

1400 10%

1200

1000 0%

800

600 -10%
05/01/1998
05/05/1998

05/09/1998
05/01/1999
05/05/1999
05/09/1999

05/01/2000
05/05/2000
05/09/2000

05/01/2001
05/05/2001
05/09/2001

05/01/2002
05/05/2002
05/09/2002
05/01/2003
05/05/2003

05/09/2003
05/01/2004
05/05/2004

05/09/2004
05/01/2005
05/05/2005

05/09/2005
05/01/2006
05/05/2006

05/09/2006
05/01/2007
05/05/2007
05/09/2007

05/01/2008
05/05/2008
05/09/2008

05/01/2009
05/05/2009
05/09/2009

05/01/2010
05/05/2010
05/09/2010
S&P 500 Liquidity Growth

Graph 2 provides a breakdown of the liquidity index since mid-2007, zooming in on the impact of the
Fed’s actions. Soon after the S&P 500 peaked in October 2007, the Fed started reducing its holdings
of US bonds, from $780 billion all the way down to $475 billion by March 2009.

On the other hand, the bank liquidity component, which had been steadily growing throughout the
decade, began to sputter after the Bear Sterns debacle in January 2008.

Graph 2: Liquidity Index Components – Jul 2007 to Present

Bank Liquidity Fed Liquidity (2) S&P 500

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The result of these actions was a severe and unprecedented contraction in liquidity growth. Once its
effect became painfully apparent in the economy (in a stunningly short period of time), with everyone
struggling to raise cash, the Fed responded with an unprecedented QE program as noted earlier.

The Fed thus effectively replaced the banks in the process of keeping liquidity growing throughout
the economy, as the private credit mechanism was severely impaired (and still is, with declines not
seen since the Great Depression). Otherwise banks would just keep on padding their reserves with
more QE. Because the Fed does not directly lend to individuals and non-financial institutions, this
could only be achieved through expanded budget deficits. Accordingly, the US government
substantially stepped up its efforts to stimulate the economy.

And here we are, barely two years later, once again contemplating doing another round of QE.

So How Much More QE is Needed?

There is no simple answer. Liquidity flows into different sectors of the economy, with some being
much more productive than others. The expectations of economic agents also vary throughout the
business cycle and the impact of each liquidity boost is different each time. For instance, a $2 trillion
liquidity injection will very likely have a different effect depending on whether equity markets are
worth $8 trillion or $13 trillion, all else being equal.

With this in mind, the liquidity index we used previously can provide a sense of the amount of QE
required to at least sustain the status quo.

The historical year-on-year growth has averaged about 8% since the late 1990s. Assuming flat bank
liquidity creation, this would mean that the effect of the envisaged $500 billion QE reportedly being
contemplated by the Fed would last until March 2011. Another $500 billion would be required to
sustain that growth through to the end of the year.

The math is actually a bit more complex than this, as asset prices tend to adjust to higher liquidity
growth rates, meaning that valuations may suffer if the growth rate declines. In other words, having a
positive growth rate is not sufficient per se to continue boosting asset prices; increasing amounts in
absolute terms may be needed each time. And if bank credit continues subdued, the Fed may need to
pick up the slack even more.

All in all, a QE program of at least $1 trillion may be required throughout 2011 just to sustain the
status quo. Boosting the liquidity growth rate into the double digits – consistent with substantial share
price gains thereafter – would require that amount to be injected under a much more compressed time
frame, likely under six months. These figures may seem innocuous at first blush compared to so many
other trillions floating around in the news, but this is a staggering amount of money.

We mentioned earlier that with private credit impaired the principal way for the Fed to pump extra
liquidity into the general economy is through budget deficits (or purchases from bondholders, but
these are not the typical Ma and Pa Kettle). So the question becomes: is the US government savvy
enough to allocate resources in a way that will quickly put the US economy back on its two feet? This
is debatable, although the history of government interventions around the world suggests otherwise.

The risk is thus that: more QE = more misallocation of resources = more need for QE in the future.

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Will the Fed Do It?

We are of the opinion that without a major economic trigger event (e.g. severe downturn),
expectations of a vigorous QE program over the near-term may be misplaced for the following key
reasons:

Uncertain economic outlook: It is not certain as of yet that the US economy will head into another
recession. Accordingly, the Fed may opt to preserve its firepower for when things really start to get
turbulent (it is worth remembering that banks are still not off the hook). If the Fed is forced to
intervene every time the economy softens, it may get stuck in a cycle of endless QE programs –
especially with interest rates now close to zero – with diminishing results each time. With the
economy no longer responding to interest rate declines and QE gradually losing its impact, what can
the Fed do for an encore? In fact, how will it justify its own existence in that scenario?

The US government cannot keep running deficits forever: As noted earlier, budget deficits have been
essential to pump liquidity into the wider economy. With a host of trade surplus nations seeking to
recycle their assets into US dollars to prevent excessive appreciations of their currency, funding the
deficit is not an immediate concern. But the US government cannot run deficits forever. At some
point interest rates will rise, which coupled with ever expanding debt levels will create exploding
interest payments. What will be the value of the Fed’s paper assets then?

Pushback from trading partners: Any resulting debasement of the US dollar will not be good news
for a number of US trading partners (Japan is a prime example). Moreover, having some integrity
with regard to monetary policy is a necessary condition to remain the world’s reserve currency. QE
has ramifications well beyond the US economy.

Ever watchful bond and gold vigilantes…: It is not exactly a ringing endorsement of monetary and
economic policies (and policy makers) when the country’s currency plunges relative to gold and other
precious metals. The bond vigilantes also spring into action at the onset of a major QE event, driving
long term yields higher and skewing the interest rate curve (which becomes “distorted” by non-
market forces).

… as well as military “vigilantes”: As demonstrated repeatedly throughout history, it is impossible to

keep military supremacy with a debased currency. Despite being technologically advanced and
having a vast sphere of influence, the Soviet Union ultimately collapsed in the late 1980s primarily
due to unsound economic policies. The Pentagon will surely be watching all of this unfold with great
apprehension.

The Fed has something to lose: A robust QE program eventually ends up undermining the value of
the Fed’s key assets: the bonds it holds (certainly the longer dated ones), the currency it controls (by
debasing it) and its ability to steer the economy (by depleting its arsenal to fight future crises).
Paradoxically, it is actually in times of turmoil that the value of such assets increases the most, as
investors flock to government bonds and seek economic leadership from the Fed. In this sense,
continuously propping up equities may not be in the best interests of the Fed over the longer-term.

The list is not meant to be exhaustive, but the point is that a major debasement of the US dollar to
combat an economic slowdown is clearly not a done deal. We are talking about a major political
decision with consequences well beyond the realm of economics, and one which will not gather the
consensus of Americans and their trading partners.

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In our view, the Fed will likely announce some type of “muscled” intervention without a clear
implementation guideline. This will keep the bears at bay (much like Japan is trying to do in order to
depreciate the yen), without overextending the Fed’s resources at this point. However, it may only be
a matter of time before the markets eventually call the Fed’s “bluff” (if one can call it that).

The wildcard is we head into another severe economic crisis. Then all bets (along with rational
economic arguments) are off. But neither scenario is positive for equities.

Concluding Remarks

The Fed is already the world’s #1 owner of US bonds and government-backed mortgage securities. It
begs the question as to how they will ever be able offload these assets and regain control of their
balance sheet, particularly without severely affecting equity markets (as in late 2007 and 2008).

With so much at stake, will the Fed roll the dice and take on trillions more at this point? Equity bulls
beware.

(1) http://www.zerohedge.com/article/goldman-qe2-launches-one-month-or-else
(2) Net of Treasury actions to absorb liquidity

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