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Tuesday November 2, 2010 - 13:53:16 GMT
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Our Answers to Our Questions

Quantitative easing has been fully priced into this market. The consensus will recognize that the coming QE will not do what it is promised to do. The optimism injected by China growth and emerging markets popularity will be neutralized, at least for the time being.

Those are our answers to our questions.

We look at a correlation chart of the US dollar index (red) and the S&P 500 (black). We notice the dollar bottomed out a week or so ahead of the S&P top. We understand that so far the price action amounts to consolidation (made up of short-lived corrections.) Meaning: the uptrend for stocks and downtrend in the dollar could just as easily resume as they could reverse, technically speaking. But the respective top and bottom are yet to be tested as we’re nearing the 48-hour countdown to the FOMC and QE2 announcement.


But considering our expectations for a potential reversal in consensus expectations after the FOMC and start of QE2 Wednesday, we think the odds lie in a reversal of the price trends of the dollar index and stocks. In fact, we’re completely confused as to why this continued talk of QE2 hasn’t fallen flat on its face already.

Buy the rumor sell the news?

Commentators seem increasingly in agreement that QE2 ...

Will not reduce interest rates and therefore will not induce refinancing or new mortgages and not prevent further pain in the real estate market,

Will not provide needed funds to corporations and thus will not incite business investment and hiring,

And will not bring about a lasting wealth effect from the stock market and thus will not create consumer demand in the face of continued deleveraging.

They are also in agreement that QE2 will raise the cost of hard assets based on speculation in commodities and thereby increase input costs that will pressure margins and further handcuff businesses and cloud their expectations for future growth opportunities.

If QE did anything the first time it was tried, it stabilized credit market fears. Those fears remain stabilized, despite the fact that lending is moving along at a rather sluggish pace because of economic concerns. QE2 may possess some of the same credit-market-impacting traits as QE1, but it also lacks the same important mainstream-economic-supporting traits as QE1, despite what Alan Greenspan says in the ‘Quotable’ section above.

The Chinese PMI number added to the list of positive economic indicators China has dropped on the markets. And investors are behaving as would be expected. Good news in China means good news for commodities and emerging markets.

Speaking of wealth effect, capital flowing into emerging markets has helped to mitigate some of the “risk” inherent in US stocks. Money has preferred the emerging markets, and the implied risk-taking sentiment from this capital flow has helped buoy US equities.

That is to be expected. But keep in mind there is a flip-side to that coin. US stocks could possess serious influence over emerging markets on the downside. That is why China and the emerging markets won’t be fully able to neutralize a major reversal in QE2 expectations.

Maybe rising EM’s provide the confidence needed to at least allow the US economy to muddle through.  The Fed seems to be banking on the backdoor benefit of quantitative easing—boost asset prices in order to boost confidence via wealth-effect transmission—as few front door benefits seem apparent.  No matter the biggest boost leads to money flowing out of the US to other higher growth areas. 

But the so-called wealth effect is quite squishy as an economic driver at best.  And given the near-term outlook for jobs and housing (not to mention declining overall consumer purchasing power as the dollar fades), a rising 401k is unlikely to have quite the add-on impact to confidence it once did.  So at best, QE2 seems to be buying time.  Buying time by pumping up asset prices and creating a wider disconnect with the underlying value being created in the real economy. 

Overshooting of asset prices based on artificially low interest rates leading which are the catalyst for the misallocation of capital has almost always ended badly.  Maybe this time it will be different.  Stay tuned.


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