Saturday, November 13, 2010

Quantitative Easing and Recent Market Behavior.... Perplexing!!!

Last week turned out to be a very eventful week, with numerous markets marking a turn on the weekly time frames. However, the most interesting development was amongst the US Dollar, Treasury bond yields and Stocks. The following figure is a visual elaboration of this interesting development:
Treasury Yield vs Stocks vs US Dollar

In short, we are witnessing a totally opposite market behavior than what was expected of Quantitative Easing. This behavior further highlights the fact that financial markets do not follow the obvious path, and presumed relationships can disappear at any time.

Quantitative Easing Background
Quantitative Easing strikes out as a logical technique to further reduce the yield of treasury bonds and to stimulate the economy, after having a near zero Federal Reserves' policy rate. In theory, quantitative easing could help in stimulating the economic activity. 
QE Proposed Cycle

QE should result in increased demand for treasury bonds, resulting in higher bond prices and lower yields. Lower yields will translate into lower mortgage rates, lower auto-loan rates and other decreased borrowing costs. These lower rates will encourage consumption by consumers and corporations. Therefore, stimulating the overall economy. Furthermore, alleviating the deflationary pressures by devaluing the US Dollar. Above all, all of these developments will prop up the stock market.

One interesting aspect to keep in mind is that bond yields can also go down because of fear trade, as what we saw in summer of this year i.e. more people coming out of stock market and entering the bond market. On the other hand, falling stock market prices can also send the yields soaring. For example, ill performing economy will cause the stock market to decline along with rising bond yields, like what happened with Greece, Ireland and Spain. Therefore, bond yields can either rise or fall along with declining stock prices based on investor's perceptions. 'Leveraged Financial Markets' by William Mawell is a very good read on this subject. 

Recent Market Behavior (April 2010 - November 2010)
During the Summer of 2010, the treasury bond yields were falling along with a declining stock market and rising US dollar. At that point, it was assumed that treasury bonds were a safety play in a tumultuous market. Moreover, there were worries about deflation with a rising US dollar. 

This perception changed in August 2010, when yields continued their down trend alongside a rising stock market and declining US Dollar. This directional change was attributed to the prospects of quantitative easing. But over the past week treasury bond yields and US Dollar have started rising sharply along with a declining stock market, which is contrary to the presumed implications of QE2, which was announced on November 3, 2010. 

Under these circumstances, are the treasury yields telling us that there is no fear associated with the recent stock market decline (which in itself is a contrary indicator), or are the investors more worried about the inflation i.e. increased interest rates in future? But if the US dollar is also rising then shouldn't one be more concerned with deflation rather than inflation? According to certain technical, Elliott Wave and sentiment based scenarios, US Dollar has started an epic upwards voyage. 

To summarize, this convoluted financial market behavior suggests that there is something significant brewing in the market place. Although, one week of reversed relationship does not mark a trend, one should closely analyze these developments and observe further economic indicators, to decipher future economic movement and to understand the true impact of Quantitative Easing. 

In one of the future articles, I will bring forward the bearish vs the bullish case for the treasury bonds. This will be a fascinating study because treasury yields have been in a persistent downtrend since 1980s, and are we near a bottom?  

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