As I noted a fortnight ago (), the permanent open market operations of the New York Federal Reserve have not only been supportive of the short-dated end of the US Treasury bond market, whereby the central bank buys in government bonds on specific dates as part of a short-term asset purchase programme, but liquidity has also been flowing out of US government bonds into equity markets. In fact, on the days in the past six weeks when the US Central Bank has bought government bonds as part of the POMO, the S&P 500 has risen 12 times, been flat once and fallen (and only slightly) twice. Moreover, the last eight consecutive days when the Fed has been buying equities have all coincided with the S&P 500 rising. As one way bets go, it doesn't get much better than this.
And given the Fed will be embarking on a $600bn programme of asset purchases between now and the end of June 2011, equating to $75bn of government bond purchases each month, then it would be reasonable to expect more of the same for equity markets since they now have a natural and substantial prop. Or as Jeremy Batstone-Carr, head of equity research at stockbrokers Charles Stanley, neatly puts it: "When Fed officials refer to 'getting the job done' what they mean is raising the price of equities. The Bernanke solution is to drive the 'wealth effect', thus pushing consumption higher and spurring the economy to create jobs. Furthermore, the second round of quantitative easing (QE2) has a significant impact on liquidity and by that we mean global liquidity."
And this is affecting a whole raft of markets. As Mr Batstone-Carr adds: "The correlation between the S&P 500 and the FTSE All Share is incredibly close, the inverse correlation with emerging markets is even stronger (92 per cent over the past two months) and the long-held inverse correlation with the commodity complex has been a feature of the investment landscape for a long time but over the past two months it has risen to a whopping 95 per cent."
It was therefore no surprise then to see some of this liquidity seep overseas into emerging markets post the Fed's announcement, as investors moved cash into rapidly rising currency countries in Asia and Latin America. It was no surprise either to see the dollar come under heavy selling pressure on news that the US central bank is dramatically increasing the supply of dollars in circulation by cranking up the printing presses once more.
In turn, the devaluation of the dollar is good news for commodity prices, and precious metals in particular, which are priced in dollars so benefit from devaluation of the greenback as they become cheaper to buy in other currencies. Moreover, these commodities are also a store of value and one that has stood the test of time, unlike the US dollar, which has lost more than half its value on a trade-weighted basis in the past 25 years.
Take the medicine
However, whether QE2 is the right strategy is open to some debate. As Toby Nangle, director of fixed income at Baring Asset Management, points out: "In our view, this is one of the greatest policy mistakes in the Fed's history. Certainly, the first round of QE worked: it addressed a huge liquidity problem with a major liquidity solution. In other words, it was the right medicine to the right problem. Two years on, the principal problem in the US is one of solvency and growth rather than liquidity. Indeed, there is currently a relative abundance of liquidity in the economy, borne out by low yields on corporate bonds and free flowing capital to businesses. Despite this, the economy faces huge headwinds in the form of high unemployment and continued issues with the housing market."
Mr Nangle does have a point as it is hard to see how a liquidity solution can possibly correct a solvency problem. Right diagnosis, wrong medicine. He adds: "The gamble the Fed is making is that the 'portfolio balance channel effect' - pushing money out of government bonds and into other assets - will lift risk asset prices and cause the dollar to fall, thus boosting the US economy and essentially scaring the prudence out of savers. The gamble is that this boosts profits and wages, rather than simply prices which would be counter-productive."
Mr Nangle may be proved right in the end, but for now investors buying commodities and piling into high-beta mining shares are acting rationally. even though there are doubts about the long-term consequences of the Fed's actions. Indeed, if the first round of QE failed to do the trick - and let's not forget that it was accompanied by the biggest fiscal stimulus in living memory - then why should QE2 be any more effective? But in this surreal investment world, let's not worry about that today and enjoy the party because rest assured when the music stops equity markets are going to be suffering from one heck of a hangover if QE2 fails to revive the US economy.
For now though it would be a brave man to fight the Fed and this is a major positive for equity markets and commodity prices in the short term at least.
