Tuesday, May 8, 2012

Quantitative easing and the stock market

With "Operation Twist" about 1.5 months away from ending I thought I'd post a chart that depicts the diminishing effects of the FED's liquidity injections on stocks.  I posted a slightly different version of this chart on 2/16:

  (click on chart for larger image)
The top panel is a daily chart of the S&P 500 while the bottom panel is a ratio chart of the iShares Barclays TIPS Bond Fund divided by the iShares Barclays 7 to 10 Year Treasury Bond fund. It's purpose is to measure the inflationary or deflationary forces in the U.S. economy.

The theory behind the TIPS:IEF ratio chart is that TIPs (Treasury Inflation Protection Securities) are bonds investors buy to provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index.  Dividing the TIPS bond fund with a bond fund that tracks the "belly" of the yield curve gives us a viable way to track whether inflation or deflation is gaining momentum in the economy.
I've highlighted the commencement of each liquidity injection (QEI - blue dashed vertical line; QEII - green dashed vertical line; Operation Twist - purple dashed line).  The solid red vertical lines identify when each program ended.  As you can see, the market got ugly after the end of the first two programs.  When "Operation Twist" ends on June 30th will the same thing happen?

In all fairness a case could be made that "Operation Twist" was largely a sterilized program in that the FED was selling Two Year US Treasury Notes and buying Seven to Ten Year Treasury Notes in order to keep interest rates low on the long end of the yield curve.  But I don't have the numbers to determine whether or not they bought more seven to ten year notes than sold two year notes.  But as a "QE" program it was not of the magnitude of the previous two programs.

Nevertheless, it appears that the FED is "pushing on the proverbial string" in its efforts to buoy risk assets.