Last November, the Chairman of the US Federal Reserve justified his $600bn QE2 programme to boost financial markets by claiming “higher stock prices will boost consumer wealth and help increase confidence“, whilst also leading to “lower mortgage rates“.
And stock prices have indeed risen. As the above chart from PetroMatrix shows, there has been an 86% correlation between the QE2 $600bn POMO purchases (Permanent Open Markets Operations, green column), and the S&P 500 stock index (blue line). Investors have also increased Margin Debt which, at $350bn, is now back to pre-financial Crisis levels.
But whilst the Fed’s money has boosted financial markets, consumers are losing confidence. The key Univ of Michigan index fell a near-record 10% last month. Consumers are not stupid, and know they will have to pay the bill for the Fed’s actions via higher taxes and spending cuts:
• In addition, of course, they are being hit hard by the rise in oil and gasoline prices. These have risen via the ‘correlation trade’, as traders use the Fed’s low-cost money to speculate in commodity markets.
• Plus, by openly encouraging this move into risky assets, the Fed has actually caused interest and mortgage rates to rise.
Now we have to wait to see what happens next. Most investors are hoping for a 3rd round of liquidity to be unleashed, once QE2 ends in Q2. But some Fed Governors are now publically questioning its rationale.
The problem is that the damage has already been done. QE3 would lead to higher oil prices, and further depress consumer confidence.
But doing nothing would be equally painful. If oil prices returned to more realistic levels, for example, demand would suffer in the short-term as the Value Chain destocked, plus companies would face major losses on working capital.