The 4Xlounge Market Insights discusses a number of the most significant economic data that we use the gauge the strength or weakness of a given economy so we may better understand the trends that emerge and go to influence the most actively traded currency pairs. In addition we may also consider the various financial markets as they react to various forms of monetary policy such as Quantitative Easing (QE) as we strive to predict how these markets may behave under the constant changing environments this stimulus creates.
Various forms of stimulus:
In an attempt to reinvigorate the US economy, the Federal Open Market Committee (FOMC) “Fed” initiated an aggressive form of stimulus known as Quantitative Easing, where ‘new’ dollars are printed, where these funds will be used to purchase long-term maturity treasury bonds with the intention of forcing long-term interest rates as low as possible in order to encourage consumers to reenter the economy and purchase ‘big ticket’ items such as homes and automobiles. In all the Fed introduced 2-rounds of Quantitative Easing known as QE I and QE II. This was followed shortly after with the creation of “Operation Twist” (OT). While the intentions were the same, the inherent difference in QE & OT can be found in the source of the capital. While QE derived the funds to purchase these long-term bonds through the printing of additional dollars, OT did not rely on the printing of new capital but rather generated these funds through the sale of short-term maturity treasury securities. Listed below is the timetable in which these various forms of stimulus took place. It is especially important to recognize the behavior of the various financial markets as the Fed in their most recent meeting (June, 2012’) announced their current round of Operation Twist, which was expected to conclude shortly, will now extend throughout the end of the year, 2012’.
As a result of the infusion of new investment capital into the economy alongside with record low interest rates many US corporations benefited from the Fed’s efforts as consumers were left with little other options as to where they may direct their investment capital. In particular notice (below) the Dow Jones Industrial Average (Dow) enjoyed a steady trend to the upside during both rounds of QE as well as during OT. In addition, note how the equity markets suffered their greatest losses during those periods of time when no stimulus was applied to the economy.
While equity markets enjoyed better than average returns under the influence of stimulus, the bond market in turn also reacted to the changing conditions. As stocks rise bond investors demand a relatively higher yield, which can be seen from the following 10-year Treasury bond chart below. What’s interesting to note is that during both rounds of QE the 10-year bond (yield) enjoyed a steady rise to the upside where as bond yields failed to follow suit during the subsequent Operation Twist. Perhaps this divergence emerged in part due to the relatively inferior stock returns during the same period of time, or perhaps we may attribute this to the very nature of both types of stimulus. Nevertheless traders may use this divergence as a sign of what may be expected as Operation Twist has now been extended throughout the remainder of the year 2012’.
We now turn our focus to the Forex market specifically considering the behavior of the USD during the various rounds of stimulus, and the time that followed. Here we can begin to see the stark contrast in the effects of stimulus as a result of their sourcing of capital. As QE purchases treasury securities through the printing of new dollars, these additional dollars tends to dilute the existing amount of USD in the economy, and in turn has added weight to the currency resulting is strong moves to the downside. Furthermore notice how the USD enjoyed its greatest moves to the upside during those periods of time following Quantitative Easing. Conversely the USD did not fall under the same selling pressure during the subsequent Operation Twist, perhaps due to the fact that ‘no new’ dollars were printed, as the investment capital to purchase the long-term bonds through the sale of shorter-term maturity securities.
We may now consider the effects of monetary stimulus as its effects can be seen through a different measure of the financial markets, namely volatility. The chart (shown below) displays the widely followed VIX (Volatility Index), which essentially measure the premium on stock options on the S&P 500 index. Generally speaking as equities rise and feelings of optimism emerges, a fewer amount of options are used to ‘hedge’ (protect) existing positions, and the VIX tends to fall. Conversely when stocks fall the VIX tends to rise as demand for protection rises. However we can also see the correlation between the Fed’s efforts and the VIX. Notice how the VIX tends to decline during those periods of time that the Fed imposes either Quantitative Easing or Operation Twist, as the VIX tends to rise when stimulus is not present.
What can we take away from this?
During the first 2-rounds of Quantitative Easing stocks enjoyed some of their best periods of performance, but while equities did rise during Operation Twist, they did not appreciate to the same extent. Does this imply that QE is more effective in boosting stock prices or does this simply illustrate that the more stimulus that is added to the economy, the less it actually helps improve conditions. Although not as extreme, stocks still did manage to accomplish ‘higher highs’ during QE II and Operation Twist, while the 10-year bond yields actually registered ‘lower highs’ highlighting another form of divergence as we would normally expect stocks and bond yields to move in the same direction. Perhaps the best example of divergence can be found in the behavior of the USD during QE as opposed to OT, but we should also make note of the fact that OT did not cause the VIX to decline as much during either round of QE. So now that the Fed has extended its current round of Operation Twist throughout the end of the year, what may we expect moving forward? Perhaps stock prices will enjoy at least a moderate degree of support, but certainly not to the same extent that we did once see. Furthermore as bond yields continue to decline and the USD rises, this may be accompanied by a moderate level of volatility measured through the VIX. Of course only time will tell, but we simply hope to use history as a guide so better anticipate the most probable market behavior in the time to come.
We wish you the best of luck in all your trading endeavors.