Stocks & QE

Would an extension of Operation Twist boost stock prices during the second half of the year? I think so, though I believe they can move higher without more monetary stimulus too. If you haven’t read Richard Fisher’s speech of March 5, you should. He is the president of the Federal Reserve Bank of Dallas. He is a nonvoting member of the FOMC, and among the frequent dissenters when he did have a vote last year. He voted against MEP. Mr. Fisher is “personally perplexed by the continued preoccupation, bordering upon fetish, that Wall Street exhibits regarding the potential for further monetary accommodation--the so-called QE3, or third round of quantitative easing.”

He does offer an explanation: “I think it may be because they have become hooked on the monetary morphine we provided when we performed massive reconstructive surgery, rescuing the economy from the Financial Panic of 2008-09, and then kept the medication in the financial bloodstream to ensure recovery.” Let’s review the market’s medical chart to see how it responded to the injections and withdrawals of the Fed’s monetary medicine:

(1) The S&P 500 rose 36.4% during QE-1.0, which spanned from November 25, 2008 through the end of March 2010.
(2) The S&P 500 rose 10.2% during QE-2.0 from November 3, 2010 through the end of June 2011. It rose much more, by 24.1%, if we start the clock on August 27, 2010, when Fed Chairman Ben Bernanke first hinted that a second round of quantitative easing was on the way.
(3) Operation Twist was announced on September 21, 2011. Since then, the S&P 500 is up 15.9%.
(4) Between the end of QE-1.0 and Bernanke’s speech on August 27, 2010, the S&P 500 fell 9.0%. Between the end of QE-2.0 and the beginning of MEP, it fell 11.7%.

There is an even better correlation between the Fed’s QEs and expected inflation implied in the spread between the 10-year Treasury nominal and TIPS yields. During QE-1.0, expected inflation rose from a low of 0.12% the week of January 2, 2009 to 2.38% the week of January 8, 2010. During QE-2.0, starting with Bernanke’s speech on August 27, 2010, expected inflation rose from 1.55% to peak at 2.62% the week of April 15, 2011. During Operation Twist, it increased from 1.82% when the program was started to 2.25% at the beginning of March.

This helps to explain why stock investors are such junkies for QE. There is a high correlation between expected inflation in the 10-year TIPS and the forward P/E of the S&P 500 (Fig. 1). QE boosts inflationary expectations by lowering the risk of deflation. That benefits risky assets and their valuation. (More for subscribers.)