Wednesday, March 18, 2015

quantitative easing

This afternoon the Fed will announce the results of its latest policy meeting. I don't think the market will learn anything new. In any event, what matters most for world stock market is the prospective effects of the quantitative easing program, past and present, which have been implemented by the world's central banks.

The top two charts show the stock market averages most effected by the two biggest and still ongoing QE programs.

The top chart is a weekly chart of the Stoxx 600 index of European stocks. The European central bank had been threatening to start a QE program for many months but its program was actually begun only a week ago. The euro currency had already dropped 20% against the dollar during the "talk-only" phase but I expect it to continue down below par as the ECB backs up the promises it has made. The ECB's QE program has been a verybullish influence on European stocks as you can see in the chart. Looking ahead  I expect to see this index trade into the 500-550 range over the next few months. And an ultimate upside target of 700 or so seems within reach as well.

The second chart is a weekly chart of Japan's Nikkei stock market index.You can look at the chart and see just exactly when the Bank of Japan's QE program was announced. The dollar-yen has rallied from 80 to 120 subsequently and I think it is  on its way at least to 145 and maybe higher than that. My upside target for the Nikkei is 28000.

The effects of the European and Japanese quantitative easing programs will be felt world-wide, not just by their domestic stock markets. In particular I think the trend in US stocks will continue upward under the influence of the flow of new liquidity into European and Japanese financial markets. This liquidity will partly move abroad since both Europe and Japan permit free international capital flows.

It is a commonly held view that QE programs work their magic by lowering interest rates. But if you look closely at the behavior of the 10 year note yield in the US during the times that the Fed was pursuing its QE programs you will notice that note yields rose when these programs were announced and continued upward until the end of the program was in sight.

The rise in interest rates associated with such programs reflects market's expectations that such programs will have their intended effects of strengthening the economy. It is the expectation that a QE program will be successful that pushes up interest rates while it is in progress. Moreover, if the QE programs does move the economy onto a higher growth path interest rates will continue upward even after QE halts.

I believe that the QE program pursued by the Fed from September 2012 through October 2014 did have the intended effect of moving the US economy onto a fast growth path. The drop in interest rates during 2014 (bottom chart) reflected a market expectation that the Fed's program would fail to do this because it was ended too soon. But I think the market is in the process of revising its beliefs about this. As it does so I think the 10 year note yield will move above 3.00 % and eventually will move much higher than that.

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