A Central Banker's Cocktail Party: Tequila or Water?

What is Quantitative Easing? A government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Now that's out of the way we can dissect the size, announcement, and long-term affects of the easing on the Global Financial System.

First let us say congratulations to the United States Federal Reserve, in eight months time you will maintain a $3 Trillion balance sheet. The Central Bank is now the largest Hedge Fund in the World. Kudos, no really. Let's take a few moments to put this number into perspective. In, 2009 the U.S. GDP was $14.25630 Trillion. The IMF forecasts growth in 2010 of 2.6%. A back of the envelope calculation puts 2010 output at 14.627. Thus, in June 2011 the Federal Reserve will control assets worth 20-21% of 2010 Gross Domestic Product. In 2007, The Fed's Balance sheet was worth only 6.4% of Gross Domestic Product. All we can say is Kudos.

Consequently, the NY Federal Reserve has a tall glass to fill:

The FOMC directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to purchase an additional $600 billion of longer- term Treasury securities...Taken together, the Desk anticipates conducting $850 to $900 billion of purchases of longer-term Treasury securities through the end of the second quarter 2011.

I expect on-campus recruiting to increase at the next NYU career fair. Anyone want to take the opposite side of this trade?

Looking Back,today's market action after the FOMC announcement was incredibly entertaining. We observed The S&P 500 oscillate down to 1183 and then rocket back to 1199 to close the session. The EUR/USD fluctuated 190 pips, a range that would make any Black Box trader proud. Gold dropped from 1348 to 1327 and now trades at 1355. Ironically, Natural Gas was unchanged throughout. The fourth of July came late this year, hope you did not miss it!

SPX

Dollar Index

Moving forward, Quantitative Easing will surely inflate Global Asset Markets. Will it? Regardless, this is the current thesis the Fed operates with. The goal of 'QE II' is to re-inflate the U.S. economy. Specifically, the Federal Reserve desires an asset re-allocation trade. The FOMC hopes to push investors out of 'safe-haven' Government Debt instruments and squeeze them into more risky asset classes such as equites, commodities, junk-bonds, and real-estate. Why would the fed want to turn the proverbial risk switch off? Don't jump to conclusions, keep reading!

The second leg of this trade hinges on the 'wealth effect', The premise that when the value of stock portfolios rise due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more . Miller Tabak estimates this effect will carry a multiplier of 3x. Hence, the $600 B of Quantitative Easing will create new consumer wealth of $1.8 Billion. The Fed supposes a multiplier of this magnitude will allow consumers to feel comfortable parting with their hard earned Dollars and spend without discretion. Therefore the economy will grow, inflation will rise, unemployment will fall, and The 'Red, White, & Blue' will flourish in economic and financial prosperity once again.

Personal Savings Rate

Even Though The FOMC's policy makers and economists are a collective of the smartest and brightest in the United States of America, Quantitative Easing II sounds too good to be true. Why you ask? First, any good trader knows timing the market is nearly impossible. Second, who is to say consumers will look at their 401k statements, feel wealthier, and decide to spend. Lastly, 'QE II'has never been done before. The original U.S. Quantitative Easing was executed during the heart of the credit crisis. The impetus for the current version is plainly different. Also, Japan's attempts fell flat and failed miserably. In short, we are critical here because we are uncertain of the outcome. The Fed should be too.

To clarify we will attempt to explain our thoughts in a simple thought experiment:

Suppose you are two hours late to a cocktail party. There is food, drinks, and irresponsible adults galore. You head to the bar for your first drink of the night. The bar tender informs you the only beverages still available are water and tequila. At the same time you approach the bar an irresponsible adult, who consumed five beverages prior to your arrival, also approaches. You think, I hate tequila because it makes me sick. Instead you decide to drink water and enjoy the experience without alcohol. Meanwhile, the irresponsible adult orders another drink. Mind you this is his 6th drink and first of tequila. You think, 'I wish I was indulged in his level of intoxication'. Though, your next thought is 'I am so happy I am not that guy, he won't be able to get out of bed tomorrow'.

Is the Fed an irresponsible adult or a water drinker? Take from this simple thought experiment what you will.

Undoubtedly, we are entering uncharted territory. Here's to watching and waiting for events to unfold. Hey, if you get bored check the BOE decision at 08:00 EST and the ECB decision 45 minutes later. Surely the ECB won't surprise!

Cheers,

--Patrick M. Ambrus

Sources: Investopedia.com, The Gartman Letter, FederalReserve.gov, NewYorkFed.org, BEA.gov

Disclosure: We are Long the GBP and short the USD.