Recent strength in US – and global – stock prices can be partly attributed to investors correctly anticipating last week’s Fed decision to restart QE (i.e. balance sheet expansion financed by reserves creation, as opposed to duration extension of the existing balance sheet under “operation twist”). A key issue, therefore, is the extent to which the “good news” has already been discounted.
US stocks have loosely correlated with the monetary base – now dominated by bank reserves – since the Fed launched QE1 in late 2008. The chart compares the Dow Industrials index with the level implied by contemporaneous bank reserves, based on a simple regression run on data since the start of 2009. The regression “predicts” that a $100 billion injection of reserves is associated with a 440 point rise in the Dow. Yesterday’s Dow close of 13,553 was 1,300 points above the level implied by the regression, based on average bank reserves in the week to last Wednesday. This suggests that the market is discounting an increase in reserves of $292 billion as a result of QE3 (i.e. 1,300 divided by 440/100).
The Fed last week committed to buying $40 billion per month of agency mortgage-backed securities until the labour market improves “substantially” while promising further action if this objective is not achieved. Assuming that purchases are fully financed by reserves creation, a $40 billion per month pace of buying would take more than seven months to achieve the $292 billion reserves boost suggested by the current level of the Dow, based on the regression.
On this simplistic analysis, therefore, investors betting on further significant Dow strength may be implicitly assuming that either the Fed will accelerate its bond-buying in late 2012 / early 2013 or continue the $40 billion per month pace beyond next spring.