Quantative Easing and its effect on Financial Market

Quantative Easing

Quantitative easing (QE) is a monetary policy tool used by some central banks to stimulate their national economies when conventional monetary policy has become ineffective. The central bank creates money through open market operations, such as buying government bonds and other financial assets, in order to increase the money supply and the excess reserves of the banking system.  Quantitative easing shifts monetary policy instruments away from interest rates, towards targeting the quantity of money. The term Quantative easing came into lime light when the US Federal Reserve announced two successive measures on March 18^th 2009 and November 2010 so as to boost the ailing US economy from the subprime crisis and the worst  recession since the great depression of 1930’s. 

US Federal Reserve is the central bank to United States created post 1907 market crash in 1913 to ensure safe and sound financial system. The main aim of the Fed is to review monetary policy aiming at providing maximum employment and price stability for a healthy economic growth. At present Ben Bernanke is the chairman to the US Federal Reserve. Post Lehman Brother Bankruptcy in September  2008 there was a complete financial meltdown with credit market freezing all over the world, we saw not only financial giants like Washington Mutual failing but also countries like Ireland and Iceland went bankrupt. With US economy on its knees the US Federal Reserve planned out a $720 billion bailout to save the American economy. With unemployment  rising Fed came out with a stimulus package called Quantative Easing plan on 18^th May 2009 to bring back US economy on path of positive growth.The first round of Quantative easing came with a stimulus package of $1.7. But it did not prove much useful to the economy, the unemployment level went from 7.2% to 10.4 % in September 2009. The US dollar depreciated by more than 11% within few months, though there was some positive sign in the equity market and again a rising equity market does not portray the real picture of the economy. Even it had very less effect on the commodity market as investors remained cautioned on investing in commodities and with demand of goods falling, commodities were trading at their lowest point. The demand for crude oil was falling and so was the price though there was some uptrend seen in the gold with gold trading in the range of $700-$930. There were several other factors responsible for soaring of gold prices such as sovereign crisis and unstable equity market people were finding gold as safe heaven for investment purpose.  On the whole QE1 failed to achieve its objective.

With unemployment rate soaring in double digit Bernanke came with QE2 on November 2010 , a stimulus package of $600 to further strengthen the US economy.  There was lots of uncertainty created across the globe as many feared that QE2 will further depreciate dollar creating a currency war with other large economies. A depreciated dollar will increase the commodity price in the world market, China feared the most of the negative impact QE2 would have on the export competitiveness , similarly with excess liquidity flow in emerging market asset could cause significant inflation in recipient countries. From here we would try to analyze the real effect of QE2 on various financial market across the globe.

Implication of Quantative Easing 2

QE consists in creating money and purchasing government debt or other financial assets to add liquidity to the markets with reduced long term interest rate. As a result of QE the government has managed to bring back the positive GDP growth while the private sectors are still weak and contracting. Now i ll discuss the implication of QE on various sectors.

Increase Liquidity: The most immediate effect of QE is an increase in the liquidity of the overall financial system. Private banks and institutional investors have re-directed the cash received into lending to private businesses or individuals. Alternatively, they focused on acquiring assets in emerging market there by making profit by generating revenues on investment made in emerging economies. They also gained from the predictable appreciation made by local currency against the US dollar. China has blamed US of devaluating dollars through QE so as to increase its Global competitiveness. This can also have a negative implication on emerging economies in the form of soaring inflation.

Equity Market: In November 2010 Ben Bernanke said that "Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending."  He successfully attained this goal as US stock market has outperformed major economies and even developing BRIC nations in past few months till may 2011 though the 3.4% gain this year is still lagging behind its long term historic pace. However the market is falling since 5 consecutive weeks, its longest fall since 2004 pulling down the S&P index by 5% and with increasing unemployment there are further chances of market making a correction by another 5% in coming weeks. 

Unemployment: The main main reason behind these QE was to generate employment  in turn strengthen the economy  but after some initial success again the unemployment rate is on a rise since two weeks and with new regulations imposed by Fed on financial institution there are chances that major investments giants such as Goldman Sachs, JP Morgan, Bank of America and Morgan Stanley might go for layoffs so as to reduce their operating cost. Increasing unemployment rate can hamper US recovery and can further pull down the equity market.

Housing: Ben Bernanke aimed at increasing the house prices through QE but after some initial positive signs the demand is falling and the housing prices has reached its minimum level since 2005 and there are very little chances of any recovery in near future, Thus we can see that QE2 has failed even at pulling the economy out of housing crisis.

Interest Rates: Ben Bernanke has mentioned that by the use of QE he tends to lower interest rates and help the housing sector and mortgage lending.  From March 18, 2009 to May 18, 2011, interest rates have risen on the 10-year Treasury from 2.62% to 3.17%, a 20% increase. Despite that the public debt has increased by 30% during the period, interest rates have nominally increased about 1% from the record lows in the 10-year Treasury hit during the financial crisis. While the Fed hasn't been successful in lowering interest rates, it has been able to contain a sharp rise in them by buying more of a third of the mammoth amounts of debt that are being offered to the market by the US government. The expected fiscal deficit for this year totals $1.5 trillion, 9.8% of GDP and an increase of 10% of the US public debt. With QE part two ending in June, one would expect that interest rates should start to rise as the market will lose one of its principal debt buyers. 

Commodity Market: QE has has influenced global commodity prices, dollar depreciation has pushed the commodity prices. Until 2004, the correlation between commodity price and the exchange rate was negative. This was because US economy slowdown would normal cause both the dollar to depreciate and the dollar price of commodity to fall. In recent years, commodity demands have been driven by large developing countries. Under the circumstance dollar depreciation, unlike the pat, has been associated with the increase in commodity price. In 2009, the dollar price of oil and copper appreciated 1.2% while the dollar depreciated 1%. With Fed holding a large chunk of US bond, it reduces the supply of safe investment asset for global institutional investors, reducing the US bond circulation in the market and low interest rate prompted global institutional investors to investment  in other financial market, commodity market attracting some investment. Traditionally , investing in commodity market has been a popular as a mean of hedging against inflation. High inflation brings down the return in bond and stock market, commodity future tends to do better in times of inflation. There was seen a sharp rise in the commodity price since 2009 when QE1 was announced, Gold gaining the most showing a rise by 80% in two years a rise from $800 to $1530 per ounce. Other precious metal such as platinum gained too. Overall it was the commodity market that gained the most from QE with commodity price soaring to new heights.

Forex Market : To fund QE Fed has to print notes, this increased the supply of dollar in the market there by depreciating the dollar in term of other currency.  This will help US in recovery as a depreciated currecy increases the competitive advantage in the world market but on long term it can boost inflation.

Overall QE1 & QE2 has helped US recover from deep recession of 2008 but the outcome has been much less than expected and the US finds itself at the same situation as it was a year earlier with stock market falling and unemployment rising.

QE3 at the Corner

With QE2 coming to an end in June 2011 there are negative signs from the Fed of a possible QE3 however Bernanke also hinted that if economy growth remain sluggish than the Fed might go for QE3. End of QE2 will hamper Fed goal of keeping interest rate low. Low interest rates makes credit cheaper promoting people to borrow, helping in increasing home prices. With US borrowing limit coming to an end and congress demanding to reduce deficit and chances of a possible US default on its payment  there are very little chances of QE3 moreover QE3 can have a catrostrophic effect starting with high inflation. 

With no further quantative easing in sight, the effects are already visible. The most effected will be commodity market as the price are likely to come down. The most effected will be gold price, since 2009 when QE1 was announced gold has seen an uptrend with prices rising from $700 to $1540. Since recession there have been several factors caused soaring of gold prices. The sovereign crisis and inflation in major developing nation, gold has attracted the investors the most. Even though other factors are still the same, the end of quantative easing will surely bring down the gold prices.  Similarly prices of other  precious mental and other commodity will also fall. The price of pulses, soybean has also been on rise post recession, the commodity future has given return as high as 36% , but soon these growth rate will ease off. 

On the whole the return from quantative easing has been much less. Bernanke in an interview said that the Japanese Tsunami  has been the major cause for downfall of market since May and the second half should see a growth pick up. He further added that there are very less chances of QE3 because a further stimulus can cause serious problem of inflation however the Fed will continue to keep the borrowing interest rate at 0.25%  to boost economic growth.