From the May 2014 issue of Futures Magazine • Subscribe!

How markets learned to ignore QE nuance

Every three-year-old understands the concept: What goes up must come down. Once people reach adulthood and assume positions of power, this apparently simple notion becomes more difficult to comprehend, whether it involves beginning wars we cannot win and will not end or pushing short-term interest rates toward 0% and following that stunt with quantitative easing. However, while commencing monetary stimulus is easy, ending it is very difficult.

Good guys, bad guys

Some financial market movements can occur relatively symmetrically as no one is told to wear either a black hat or a white hat during the process. For example, if the price of corn goes up, we note the gains in a world without subsidies go to the farmers and the losses to the livestock feeders or ethanol distillers, and get on with our lives. If, however, stock prices go down, the deadweight welfare loss for investors greatly outweighs the opportunity gains for new investors to buy stocks more cheaply. The same phenomenon applies to housing prices, as we all saw in excruciating detail during the financial crisis and its aftermath.

Another asymmetry involves interest rates. As economies tend to have many more borrowers than lenders, and as higher borrowing costs can put those borrowers out of business while lower interest income is not as lethal to lenders—policymakers tend to regard lower interest rates as good and higher interest rates as bad. Moreover, the largest single debtor is the federal government; the convenience of having the Federal Reserve turn into the largest buyer of Treasury securities, as it has been since 2009, cannot be overestimated.

Lower interest rates become embedded in the system; the lower cost of debt service for mortgagors, corporations and the public sector at all levels encourages higher overall levels of debt. In addition, as monetary stimulus can push short-term interest rates down far more effectively than it can long-term interest rates, borrowers have an incentive to shorten the maturity of their debt structures and assume greater rollover risk. The reduction and absurdum of rollover risk was seen in gory detail back in 2008 when investment banks dependent on overnight repurchase rates discovered just how quickly they could be put out of business.

Market responses

All of these distortions have affected futures markets as well. Once short-term interest rates are pushed to artificially low levels; and once long-term rates are distorted as they have been since August 2011 by Operation Twist; and once stock prices are pushed higher by a Federal Reserve trying to create a wealth effect from QE2 in November 2010 onward, traders have a vested interest in guessing the next move.

FOMC officials themselves contribute to the guessing game by airing their disagreements in public and by changing the criteria for slowing, stopping, resuming and accelerating money printing.

But if markets are rational, they should gravitate toward some measure of policy permanence and ignore the short-term communications noise coming from all sides of the equation. As we will see, the stock market began to get to this point with the anticipation of QE3 starting in June 2012. It took the Treasury market longer to figure out they were being toyed with; the bond market did not start ignoring the noise until the QE3 tapering began in December 2013.

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