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Stock Prices And The End Of QE2. QE3, Anyone?

The U.S. stock market is recovering to levels from before the financial crisis, just in time for the expiration of the second round of the Fed's quantitative easing, which we all call QE2. Market strategists, smart people, are developing arguments as to how the risk markets -- stocks here and abroad, commodities, and corporate and high-yield bonds -- could sell off when the Fed backs away from buying large quantities of Treasury bonds come June. The Fed's buying surely has pumped up stocks, but the long-term answer probably lies in whether the programs have strengthened the economy, and built investors' confidence, to levels high enough that the market props aren't necessary.

To review, the idea behind QE2 was for the Fed to buy Treasury bonds, to keep interest rates low and help the economy grow. Housing doesn't seem to have gained any ground, but unemployment is a little better than it was, and moving in the right direction.

What the strategists are focused on, however, is the tactics of QE2 and how the markets may have been distorted by the purchase of $600 billion in government bonds.

The Financial Times' Alphaville blog lays out the details:

The Federal Reserve buys US Treasuries from investors in the hopes of pushing them into things like corporate credit, but at the same time the central bank's purchases decrease UST supply. They squeeze investors from 'safe' US Treasuries into riskier assets.
The very fact that net supply of new debt and bank lending has been weak strongly suggests that the impact of QE2 has been a risk asset price phenomenon and not a loan creation phenomenon.
That is, banks have not done their part in using the liquidity to lend money to businesses for new projects -- instead, investors have put it to work in the markets.

Here is a graph showing interest rates and the S&P 500 for the last several years, highlighting the QE periods:

Click to enlarge
There have been many other influences on the markets over the period, but there's a strong association between a rising stock prices and QE.

The FT continues, on the wisdom and outcome of QE2:

[First, that banks didn't lend more] doesn't mean QE2 was a waste of time. On the contrary, the alternative may have been much worse. Loans may have been destroyed at an even faster pace. Second, the mere end of QE2 may result in sharp declines in risk asset prices. Third, the actual withdrawal of QE2 could be very damaging - and interrupt any rise in Treasury yields that might otherwise be occurring. Fourth, it suggests that the Fed may tread very softly around the end of QE2. I.e. it would be risky for them to use the end of QE2 as a segue to either asset sales or changing the language.
Investors have become accustomed to the Fed's help and will expect more.

The Wall Street Journal wrote the other day about the end of QE2 as well, but didn't reach a real conclusion:

Although equities tumbled after the Fed wrapped up QE1 in 2010, "the economy is much stronger now," says Joe Zidle, an investment strategist at Bank of America Merrill Lynch. The Fed's low-interest-rate policies "succeeded in turning skeptical investors into confident investors," he adds. The ultralow interest rates have made stocks a more attractive alternative to bonds, Zidle says, while rising sales and profits at many S&P 500 companies should sustain stock prices.
If bond yields do creep up after QE2 ends, then bonds could start siphoning money away from stocks, Zidle says, but he doesn't see that happening until the yield of the 10-year Treasury is around 5 percent. Many strategists are predicting that the yield of the 10-year Treasury will rise to around 4 percent by the end of the year, up from 3.4 percent recently.
More about those stock prices: at the fundamental level, they are supported by the levels of corporate profits and dividends. I wrote about two weeks ago that analysts were forecasting strong earnings growth for 1Q 2011, at about 14 percent year over year, and that the one-year-forward estimates call for profits to be rise by almost 18 percent. That outlook was thought to be dented a little by the effects of the terrible Japanese earthquake and tsunami, but in fact estimated growth today, incorporating the actual 1Q 2011 of about 30 percent of the S&P 500 companies, now stands a little higher, at 18.2 percent.

The question is, then, have QE1 and QE2, and the pressure of the money the Fed pumped into the financial markets, been the main force behind the moves in the stock market? Or has that just helped on the margin, and the markets mostly reflect the improving economy?

For the record, here is the S&P 500 plotted against corporate profits from the GDP figures since 2007 -- they slipped a bit in the fourth quarter, but are nonetheless higher than before the financial crisis.

Click to enlarge
This is another case where nobody really knows. Pushing investors out of Treasuries and into riskier assets surely has helped the prices of stocks and commodities. The more important question, I think, is whether the U.S. economy will be strong enough boost investors' confidence and pull the stock market along. We still have outrageous unemployment and the large retailers say consumer spending is growing at a pokey three percent. Probably not slow enough to warrant a third round of QE, however. Without an acceleration at the basic economic level many investors could decide to wait it out.

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