Stefane Marion, NBF Chief Economist and Strategist

September 14, 2012

For this week’s strategy note, we have included a timely update from NBF’s Chief Economist and Strategist Stefane Marion following the FOMC announcement of further quantitative easing on Thursday, and what it means for markets. Led by the resource sector, the TSX was up 1.8% for the week. Gold traded at highest level since February and WTI crude traded at $100, first time since May. The S&P was up 2.2% on the week.

Ben Bernanke launches an open-ended QE

As it turns out, the words “fairly soon” referring to the timing of further stimulus in last month’s Fed minutes meant September the 13th. The Fed indeed delivered a double dose of extra monetary policy stimulus today while keeping rates unchanged at zero.

Firstly, the FOMC decided to extend by six months “at least through mid-2015”, the period over which it expects to maintain the target range at 0-0.25%. Secondly, and perhaps more eagerly anticipated by markets, the FOMC decided to embark on a new asset purchase program i.e. the long awaited QE3. The Fed will purchase agency MBS at a pace of $40 bn/month without specifying an end-date to the program. In other words, that’s an open-ended quantitative easing program. Operation Twist will continue as announced in June, meaning that, together with today’s new measures, the holdings of long-term securities will grow by $85 bn/month through the rest of the year.

The Fed made clear that if the labour market doesn’t improve substantially, it will continue its purchases of MBS, undertake additional asset purchases and employ other policy tools. Supporting its decision today, the Fed explained that it is concerned that, without further stimulus, economic growth may not be strong enough to generate sustained improvement in labour market conditions. Crucially, the Fed made clear that the highly accommodative stance of monetary policy will remain appropriate for a considerable time even after the economic recovery strengthens.

What next for equities?

Following the Fed’s announcement, equities jumped to a new cyclical high and the S&P 500 is now trading at over 13 times forward earnings, the highest level since QE2 was launched back in November 2011. Our chart shows that the market does not really provide PE expansion after QEs are launched. This time could be different though.

[Chart Here]

For one, previous QEs were initiated at a time where home price deflation was pervasive. This is no longer the case. Households are no longer suffering from a negative wealth effect and commercial banks are actually increasing residential loans. For another, this is an open-ended QE aimed at reducing the unemployment rate. Under such conditions, we think that the Fed is much more willing to “err” on the side of more inflation. The commitment to buy $40 billion a month of securities means that the monetary base will swell to $3,200 billion over the coming year or close to 20% of U.S. GDP. Recall that the monetary base is “high-powered” money. In other words, should corporations and households opt to borrow more and financial institutions decide to increase their loan books, a multiplier effect would kick in and propel money supply to much higher levels. In our view, this type of environment is extremely positive for bullion. As the chart below shows, a rising monetary base is always favourable to bullion. Add a little inflation coming from food and energy and the fact that the Fed is fine with trashing the greenback (to generate export jobs) and trick is done. We should breach $2,000/once relatively soon.  From a currency perspective, the Canadian dollar is on the receiving end of QE3. Bank of Canada Mark Carney said last week that “only” 40% of loonie appreciation was due to USD depreciation since 2002. With this proportion now only likely to increase, can the Bank of Canada really maintain a tightening bias for much at its October meeting?

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