Beware Greeks (or the US Fed) bearing gifts
In an unprecedented gesture of goodwill (an early Christmas present perhaps?) the global economy has received a huge gift in the form of the US Federal Reserve’s announcement of a fresh round of Quantitative Easing (QE). This has been perhaps the biggest story to emanate from the US in several months (the Republican Party’s trouncing of the Democrats in the US mid-term elections hardly gets a look-in). The Federal Reserve announced that it intends to buy $600 billion worth of Treasury securities by the middle of next year.
When the first round of asset purchases was announced in December 2008, the justification for the action was widely accepted as valid. By lowering the yield on the Treasuries it purchased, the Fed’s aim was to reduce borrowing costs for a range of private borrowers. The aim this time round is less clear cut and there has been much debate regarding the effectiveness of the latest move. Is it designed to lower borrowing costs or to prevent deflation? Is it to boost asset prices and induce consumer spending through the feel-good factor? Is it to lower the dollar and boost US exports? Will it work?
Whatever the objective, clearly investors have decided it is a good thing. As I write on the day after the announcement the Dow Jones is trading up around 1.6 per cent and the FTSE 100 is up by an even more remarkable 2 per cent or 120 points. To the naked eye it might seem bizarre that markets would respond so positively to a signal that the world’s largest economy is still in dire straits, but it was virtually inconceivable that a new round of QE would not have been launched: the central bank had prepared the way, equity markets and commodities had rallied and the dollar had fallen. To have done nothing would have risked a sudden reversal and a huge loss of market confidence.
In order to understand why markets reacted this way we need to have a look at market psychology. The equity market rarely reflects current economic circumstances; instead it anticipates the environment a year or eighteen months ahead (apart from times of extreme distress such as in the wake of the Lehman crisis when it was feared that the banking system would collapse and there would be no economic tomorrow). Thus equity investors are not looking at the current, arguably dire situation - unemployment continuing to rise, house prices looking set for a further fall - instead they are banking on the fact that QE will counter these effects and that a year or two down the line things will be much rosier.
A note of caution though: the Fed may be pushing on a string. It has already thrown much at the economy and still cannot resuscitate it. More direct action through tax cuts and other additional stimuli may be needed and this week’s Republican mid-term gains make that more of a possibility.
Wherever the US leads, the UK usually follows and there remains a possibility that QE will be resumed here too, possibly in the New Year. Tax cuts look a little less likely!
This does not constitute a recommendation to buy or sell investments and the value of any shares may fall as well as rise. Investments carry risk and investors may not receive back the amount invested. The views expressed are those of the author and not necessarily of SWIM.
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