US stocks have displayed a positive correlation with bank reserves (i.e. banks’ account balances at the Fed) since QE1 was launched in late 2008. A post on 18 September noted that the Dow Industrials index, then at 13,553, was 1,300 points above the level implied by the current level of reserves, based on the historical relationship. Put differently, the market seemed already to be discounting unsterilised QE3 bond purchases of $40 billion per month sustained until spring 2013.

Since the prior post, the Dow has corrected while QE3 has started to boost bank reserves. (The latter effect has been slow to come through because of delayed settlement on the Fed’s purchases of mortgage-backed securities.) The index deviation from the level implied by current reserves, therefore, has fallen to 970 points. The Dow, moreover, is now slightly below the “forecast” for the end of the first quarter of 2013, assuming that the Fed maintains a $40 billion monthly rate of QE3 purchases – see red dotted line on chart.

“Operation Twist”, under which the Fed swaps $45 billion a month of short- for longer-term Treasuries, is scheduled to finish at the end of 2012. Many commentators expect the Fed to boost QE3 bond purchases to $85 billion a month at this time. The implied level of the Dow at the end of the first quarter under this scenario is more than 13,700, 600 points higher than currently – dotted green line.

This analysis, admittedly simplistic, suggests that the correction in equities is creating a buying opportunity, assuming that the Fed maintains its commitment to liquidity expansion at least through next spring – plausible given perceived economic risks stemming from the “fiscal cliff” and global fragilities.