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Quantitative Easing — Fiscal Deficit-GDP Growth:

Quantitative easing has been a trendy term in financial blogs during the last three years. Quantitative Easing or QE is a sophisticated way to refer to money printing by a central bank.

QE consists in creating money and purchasing government debt or other financial assets to add liquidity to the markets.

The Federal Reserve has used QE to buy mortgage backed securities, US Treasury Securities, US agencies debt and Treasury Inflation Protected Securities.

The Fed claims that it has engaged in the use of QE as a tool to support mortgage lending and housing markets with lower interest rates, promote maximum employment and maintain stable prices in the economy after a period of sharp economic contraction and financial turbulence.

This all sounds very nice but QE has also been used as a mechanism in which the US Treasury has access to cheap financing through monetization of debt.

Since the financial crisis hit, the US government has implemented a vigorous fiscal stimulus via deficit spending. By growing the government, the U.S. has been able to produce a positive GDP growth while the private sector remains weak and contracting.

Since quantitative easing was formally announced on March 18, 2009 to May 26, 2011, the U.S. public debt has grown by 3.31 Trillion. During this period until the end of June 2011, the Fed will have monetized 1.2 trillion in Treasury securities by the use of quantitative easing, monetizing about 36% of the $3.31 trillion of additional public debt that has been incurred to date.

The Fed has also become the No. 1 US debt holder.

Note that by deficit spending public debt has grown by $3.31 trillion and U.S. GDP has increased from Q2 2009 to Q1 2011 by only $976 Billion. This shows that the recovery has been weak and that the private sector is still debilitated.

If the fiscal deficit spending is aggressively cut, it would cause an immediate recession in the U.S. economy.

One of the reasons Bernanke has justified the use of quantitative easing is the high unemployment levels and the sluggish job recovery since the financial crisis. By looking at the following chart one could conclude that quantitative easing hasn’t been very successful in aiding the unemployed.

As you can observe, unemployment levels have remained stubbornly high over 9%, the population participation rate in the labor force has constantly decreased and the employment-population ratio has shown no signs of improvement during the last two years.

Regarding employment one could conclude that quantitative easing hasn’t produced a good result.

The Federal Reserve has mentioned that QE has been implemented to support mortgage lending and housing markets with lower interest rates.

Have the housing market or housing prices staged a recovery thanks to the use of QE?

Let’s analyze the trends of New Home Sales and the Case-Shiller Home Price Index.

New Home Sales have continued their decline since QE started and have just stabilized during the last few months at very low levels. Actually the current New Home Sales are at record lows since the series started in 1963.

In the other hand the Case-Shiller Home Price Indices have started to decline once again. The Composite 20, which measures home prices in 20 major US cities, is near the trough it hit on 2009.

QE has clearly failed to recover the housing sector and at best, has reduced the rate by which it is weakening.

Ben Bernanke has mentioned that by the use of QE he pretends to lower interest rates and help the housing sector and mortgage lending.

Let’s analyze if by the use of this monetary tool, the Fed has lowered interest rates. We will use the 10-year Treasury yield as a proxy for interest rates.

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. The size of the Fed’s balance sheet shows low correlation with the yield of the 10-year treasury.

The Federal Reserve is the biggest holder of US debt and will monetize $1.2 trillion of treasuries by the end of June. That is approximately 36% of the $3.31 trillion of debt the US Treasury has emitted since the start of QE.

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 this June, one would expect that interest rates should start to rise as the market will lose one of its principal debt buyers.

Quantitative Easing Effects on the S&P 500:

In November 2010, Ben Bernanke defended quantitative easingin the Washington Post by stating that: Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.

Let’s analyze if quantitative easing has effectively boosted stock prices since its inception.

The massive expansion of the Fed’s balance sheet started in September 2008, when the collapse of the banks and federal housing agencies was occurring. The Fed started a series of emergency lending programs and monetized billions of Mortgage Backed Securities and Federal Agency Debt in order to inject liquidity to the market and help avoid the bankruptcy of the financial system, which would have caused an economic disaster.

Although the Federal Reserve aggressively expanded its balance sheet, the liquidity provided didn’t help asset markets rise as panic mode was on and the liquidity was being used to avoid the collapse of institutions.

However, from December 16, 2008, when the use of quantitative easing programs started to be hinted by the Fed, we can observe a very high positive correlation between the expansion of the Fed’s balance sheet and the gains in the S&P 500.

The Fed Balance Sheet and the S&P 500 have an 88% positive correlation during the period.

Based on this evidence we can conclude that QE has been effective in boosting stock prices.

Quantitative Easing Effects on the Dollar, Gold and Commodities:

When the Fed started the use of quantitative easing there was a lot of talk that this would destroy the dollar. The Dollar Index has declined 6.2% since quantitative easing was first hinted in December 17, 2008.

While there is some negative correlation between the size of the Fed’s balance sheet and the dollar index, the greenback is affected by a variety of factors such as US GDP growth, risk aversion and monetary policy of other major central banks. The Japanese yen and British pound have also been debased in their own versions of QE, and thus a stronger decline in the dollar has been muted.

We can conclude that quantitative easing has been negative for the dollar, but the effect has been muted and distorted by other factors.

The effects of an expansion in gold and commodities are much clearer for gold and commodities.

Using GLD as a proxy for gold, we observe an 88% positive correlation between the price of this precious metal and the size of the Fed’s balance sheet.

For commodities, using GSG as a proxy, we observe a 78% positive correlation during the same period.

We can infer that an expansion of the Fed’s balance sheet is positive for hard assets such as gold and commodities.

Conclusions and Forecasts:

Analyzing the effects of quantitative easing in the US economy, public debt, employment, housing, interest rates, the stock market, the dollar, gold and commodities, we can draw the following conclusions on the effects of this monetary tool that is being applied by the Fed.

By the use of quantitative easing the FED has:

- Helped finance, through monetization, the large of amounts of debt emitted by the US Treasury in order to stimulate the US economy through deficit spending.

- Maintained low interest rates on Treasuries despite an increase of 30% in the public debt. It has done this by buying approximately 36% of the debt emitted since that start of quantitative easing and becoming the largest holder of US debt.

- Stimulated stock prices and created a wealth effect, at least in nominal terms. There is a strong, positive correlation between the size of the Fed’s balance sheet and the price of the S&P 500.

- Weakened the dollar in a muted fashion. Although quantitative easing is negative for the dollar because it increases the supply of the currency, other factors such as US GDP growth, risk aversion and other major central banks monetary policies have stemmed the decline of the green back.

- Stimulated the price of gold and commodities. There is a strong positive correlation between the size of the Fed’s balance sheet and these assets. Quantitative easing has inflationary consequences that need to be monitored.

By the use of quantitative easing the Fed has failed to:

- Reduce unemployment in a meaningful manner. The unemployment level has remained stubbornly high over 9%, the participation rate of the US population in the labor force keeps decreasing and the employment-population ratio is still at recession levels.

- Create a recovery in the housing market. New home sales are currently at record lows and the Case-Shiller Home Price Index after a brief rebound from its lows, is once again heading downwards. Adjusted for inflation, home prices are at new lows.

- Create a sustainable economic recovery. During the first quarter of 2011 GDP was lower than expected and everything indicates that this quarter’s GDP will also disappoint. As fiscal spending started to contract during 2011, so did the economic activity in the country. The private sector still remains weak and can’t make up in the short term the reduction in fiscal spending to keep the economy recovering out of the recession at a brisk pace.

With QE part two ending on June 30, this is what I expect will happen in the short to medium term in the following factors or assets.

Fiscal Deficit: Will remain very high but government spending will decrease and thus it won’t be a growth factor for the economy. With a Republican majority, a near 100% Public Debt/GDP ratio and the end of quantitative easing it is improbable that politicians can continue growing the government and thus fiscal spending won’t be able to stimulate growth going forward.

tiny.cc/re6qq)

Unemployment: With a weakening economic recovery I expect unemployment to remain high and probably increase during the next quarters. During the last seven weeks jobless claims have been consistently over 400,000, a reading that doesn’t bode well for unemployment levels.

Interest Rates: With the end of quantitative easing the Fed will be absent to be a major buyer of US debt. Thus, I expect interest rates to rise meaningfully in the short term. Taking a long position in TBT is a trade that could profit from this scenario.

Housing: This sector has continued to weaken despite quantitative easing, and I would expect it to weaken further as this monetary tool stops being used. Also, rising interest rates are a negative factor for housing.

Stock Market: We have observed a very strong correlation between the size the Fed’s balance sheet and the performance of the stock market. Thus if the Fed’s balance sheet stops expanding once quantitative easing ends one could expect that in general, conditions for stocks become less favorable.

tiny.cc/uxib4) the stock market will probably head lower during the coming quarters.

To make money going long stocks in this environment, quality stock picking will be crucial. Choosing companies with sustainable and high profit margins, with a strong economic moat and whose business benefits from growth from faster growing emerging economies should be the selection criteria. Buying them at compelling valuations will be key.

Based on that criteria, I think Microsoft MSFT is an attractive choice.

Dollar: With less currency emitted into the market as quantitative easing ends a negative factor for the greenback’s price is removed. Thus I would expect to see a stronger dollar in the next quarters.

Gold and Commodities: Both of these assets have shown a strong correlation with the size of the Fed’s balance sheet and thus a weaker performance is expected after QE part two ends.

If we add to the equation a rising dollar the probability of them heading lower increases.

However, in the case of gold It could still go up in the coming quarters depending on what other major central banks do. If we get quantitative easing like programs from them and major currencies get debased, gold could show a strong performance albeit the end QE2 by the Fed.

Also if fiscal solvency problems intensify in Europe, gold could keep escalating higher.

Quantitative Easing. I would expect this monetary policy tool to be implemented once again by the Fed in a couple of quarters. The US Treasury, facing fiscal deficits that will probably remain over a trillion dollars for as far as the eye can see, will need help with the financing and thus monetizing debt becomes an obvious choice.

If with the end of quantitative easing we start to see a weaker stock market, housing market and sluggish GDP growth, I think the Fed will conclude that conditions warranting further monetary stimulus are present.

If that happens, commodities, gold and stocks will once again have a potent tailwind to drive them higher once again.

About the author:

I am a financial analyst and professional investor from Santiago, Chile.

I am the editor and founder of the site www.globaltradingpad.com

For years I have studied the techniques of master investors and traders to create my own style. Asides from finance, I’m an avid sportsman and also an experimented musician and drummer.