4th November 2010
Outlining its plans for additional quantitative easing, dubbed QE2, yesterday, the US Federal Reserve said the injection would be in carried out in doses of $75 billion per month. The programme is pretty much in line with market expectations.
Over the past month or so, risk assets have responded positively to the expectation of QE2 from the Fed, reflecting the market's view that yet more dollars will need to find a home. It indicates to Philip Poole, global head of investment, the most likely path of travel for the fresh dollar injection will be into this asset class.
The injection of fresh liquidity by the Fed is being justified on the basis that with US rates already hovering close to zero but unemployment uncomfortably close to 10%, more needs to be done if the recovery is not to falter.
But, as Poole says, this is despite a general belief that the transmission mechanism for the injection, via the financial sector to the real economy, "is likely to be weak at best, given the excess liquidity that is already in the system".
The justification seems all the more odd considering that with the US mid-term elections out of the way, and the Democrats having been routed by Republicans as expected, government taxation and spending policy in the US is likely to become tighter, with the Grand Old Party highly unlikely to agree to extend President Obama's loose fiscal policy to date.
For Poole, that means "it is more and more likely that monetary policy will have to stay ultra loose for longer in order to take the strain".
What does this all mean for investors, or more specifically, assets?
Poole says that when it comes to trying to figure out the impact on asset prices, it has to be recognised that there is a fundamental tension between concerns about weakness in US and global activity and the resulting commitment to a monetary policy that will keep the market's liquidity ‘comfort blanket' in place.
In his view, however, a double-dip recession still looks less likely than continued low to moderate global growth in which emerging economies significantly outperform the developed world.
"This low grade growth scenario in much of the developed world should, I believe, keep both policy and market rates there very low for a long time to come and financial markets awash with liquidity.
"On balance, this combination is likely to prove positive for risk assets."
The overall impact of US QE2 therefore will be an increase in investor appetite for risk allied with the increased emphasis on securing higher yield and return.
That, for Poole, means the Fed's latest dollar injection" is likely to leach out of the US and head for cheerier climes – including emerging markets assets and select commodity currencies in the developed world".
Poole believes this is all putting unwelcome pressure on currencies and asset prices and helping to fuel broader inflation risks in emerging economies.
It can forcefully be argued that central banks in these markets should be looking to tighten monetary policy to ward off inflation.
But there is a catch: raising rates when the Fed and other developed world central banks are on hold only increases the interest differential and the attraction of the carry on these currencies, potentially sucking in even more QE-related liquidity, which I believe compounds rather than dampens bubble risks.