How QE Moves the Markets

by: Paulo Santos

There is always some discussion about whether the Fed has more bullets or not and whether QE makes any difference to the economy or not. But there shouldn’t be much discussion of the impact quantitative easing has on the market.

It’s important to understand how QE works and moves the markets, to know that if and when further QE is announced, you really can’t stay short the market. Basically, when the Fed is implementing a huge, hundreds of billions of dollars’ worth, QE effort, the Fed goes out and buys public debt from other market players in the secondary market.

Now, this is where it gets interesting. It’s not the Fed buying itself that moves the other markets; it’s what those that sell to the Fed do afterwards.

The sellers to the Fed are a very diverse group of institutions, you’ll get central banks selling, you’ll get pension funds, banks, insurance companies, etc. But most share something in common: when they sell, they need to turn around and buy something else. What they buy afterwards depends on their nature; most of what they will buy will be similar assets, or closely related assets. This is the reason why the closest substitutes to what the Fed is buying are the most affected – hence you get huge runs on other forms of debt, right up to high yield debt.

But thing is, the Fed buys so much ($1.375 trillion on the first QE effort, $600 billion on the second), that even a small % of that money getting substituted by higher risk assets, mainly by the most diversified sellers selling to the Fed, is a huge amount of money for those risk assets. Hence, the Fed buying tons of public debt ends up moving every other market through this substitution effect. And it does so mechanically.

This is the reason why if and when the Fed announces another huge QE effort, you mostly cannot be short anything, except the dollar. And when will this end? This can go on forever, if the dollar doesn’t implode completely (which would have to be accompanied by inflation).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.