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QE3, or quantitative easing 3, lingers in the back of investors’ minds.
Few investors seem to know exactly what quantitative easing really means.
We’ll take the time to explain it now.
QE3 Explained
Quantitative easing is a simple concept: a central bank “prints” money to buy long- and short-dated government debt. The goal is to drive down interest rates, boost demand for investment capital, and increase economic output.
Supply and demand are equally powerful forces in the currency and debt markets as they are in the market for shoes, toothpaste, or jelly beans. Increasing supply means lower prices. For currency, the price is not only the current price, but also the future price—interest rates.
Many think that quantitative easing 3 will never come. The Fed has agreed to make the market for dollars liquid with a promise to keep interest rates at 0-.25% for the next two years. That action alone should keep the price of money inexpensive enough to end all talk of QE3.
Effects of QE3
We can’t predict with certainty what the Federal Reserve will do to boost output, stave off deflation, and promote general economic growth. However, we can explain how QE3 will affect the markets, pending that it does eventually come:
- Lower Treasury Yields – The Federal Reserve is authorized to buy US Treasuries with freshly printed dollars. When the Fed bids up the price of US Treasuries, the yield on US Treasuries moves down. This is true for any bond—price and yield are inversely-related.
- Lower dollar value – By nature of any quantitative easing program, the Fed must create more dollars to buy up US Treasuries. Naturally, this results in a lower dollar value against other currencies, as the price of the currency is dictated primarily by supply and demand.
- Inflation concerns – It happens every time the Fed acts to loosen monetary policy. Inflation remains low in the US, but a small group of investors worry that quantitative easing will lead to inflation. The reality is that the Fed would like to see inflation, since it has thus far failed to create any real measurable amount of it. Deflation remains a top concern.
- Rising asset prices – Assets are priced into the future, whether we’re talking about stock prices, or the price for a barrel of oil. When the time value of money falls, investors can pay for earnings further out into the future. Bernanke made it clear his goal was to boost the financial markets, and that means giving lift to asset prices.
See? Economics doesn’t have to be difficult to understand!
When looking at the Fed’s options for tomorrow, there are about three outcomes that are most likely and each will create its own market reaction.
Scenario 1: The Fed introduces QE3 to the world with the promise to purchase $850 billion of longer-term Treasury securities.
Scenario 2: The Fed introduces QE3 to the world with the promise to purchase less than $500 billion of longer-term Treasury securities.
Scenario 3: The Fed does not introduce any form of QE3 and again repeats the mantra that they are frustrated with the current pace of growth of the economy, but isn’t bad enough for them to use such an extraordinary monetary policy tool such as Large Scale Asset Purchases.
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Moodys said it will lower the United States credit rating unless budget negotiations but the country on a path to a lower debt-to-GDP ratio. The headlines sparked a rout on the US dollar; the Australian dollar was the top performer. Japanese machine orders and Australian housing starts are the highlights in Asia.
Today is much like Friday as the entire market awaits two key announcements this week. First, on Wednesday the markets look to Germany to hear if they are on board with ECB plans to buy bonds from the likes of Spain, Greece, Italy and others. Then on Thursday, the markets look to hear from the Federal Reserve. The markets are again looking to hear whether or not QE3 will be announced.
With these two major announcements on the horizon, the markets are likely to stay quiet until Wednesday.
Gareth Soloway
Chief Market Strategist
www.InTheMoneyStocks.com
As the world awaits the announcement of the German constitutional court regarding the legality of the ESM mechanism, on this side of the Atlantic the focus remains squarely on the Fed as its holds it monthly FOMC meeting which concludes on Thursday.
Boris Schlossberg
SYDNEY (MarketWatch) — Asia shares tumbled Tuesday with declining commodity prices and fresh signs of weakness in the U.S. economy hitting stocks ahead of key events later in the week.
What the market wants is a clear road map for Fed policy. They want to be told definitively that the central bank will or will not ease next month. Unfortunately being straightforward has never been one of the Fed Chairman's strongest personality traits and hoping for a clear road map tomorrow may be wishful thinking. Yet the one situation where Bernanke could still drop hints about easier monetary policy is if they already agreed to ease monetary policy through something other than Quantitative Easing. One possible option would be to extend their low rates pledge beyond 2014 or to tie interest rates with economic data. Both of these options would mark an important shift in U.S. monetary policy and is less drastic than a third round of Quantitative Easing and cheaper than asset purchases.
However there are plenty of reasons why Bernanke could choose to remain elusive about monetary policy. While the world was surprised by how close the Fed was to increasing stimulus in early August, the economy has improved since then. According to the Beige Book, there are signs of life in parts of the U.S. economy and continued challenges in others. The lack of consistency in the U.S. economy is the very reason why Bernanke could choose to wait until the latest official Fed forecasts are completed and the next non-farm payrolls report is released before committing to any fresh policy changes. Also, having provided signals to major policy changes at the last 2 Jackson Hole Summits, Bernanke may want to move away from the expectation that Jackson Hole is a forum for announcing policy changes.
However there are plenty of reasons why Bernanke could choose to remain elusive about monetary policy. While the world was surprised by how close the Fed was to increasing stimulus in early August, the economy has improved since then. According to the Beige Book, there are signs of life in parts of the U.S. economy and continued challenges in others. The lack of consistency in the U.S. economy is the very reason why Bernanke could choose to wait until the latest official Fed forecasts are completed and the next non-farm payrolls report is released before committing to any fresh policy changes. Also, having provided signals to major policy changes at the last 2 Jackson Hole Summits, Bernanke may want to move away from the expectation that Jackson Hole is a forum for announcing policy changes.
Kathy Lien
Managing Director
BK Asset Management
295 Greenwich Street, Suite 281
New York, NY 10007
Direct Line: 1-917-538-6971
Fax: 1-925-887-4373
