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So folks, we are not only at another critical juncture in the economy, but at a point we have been at before. For yesterday the Federal Reserve signaled we will be going back to the future ... through another round of economic stimulus (QE3). So let us place ourselves in the shoes of Marty McFly and consider: to understand the future, we need to go back to the past.

<---THE START--->

What is quantitative easing (QE)?

QE is essentially a form of stimulus. It involves expanding the US balance sheet by printing money and then using it to buy assets to stimulate the economy. These assets in the past have been US government debt or mortgage-backed securities to keep interest rates low to spur on lending and borrowing.

<---BACK TO THE PAST--->

The first bout of QE was announced in November 2008, and was extended in March 2009 to run for a year. It involved purchases to the tune of $1.25 trillion of mortgage-backed securities and $300 billion of US government debt. March 2009 was also the belly of "the Great Recession," and a turning point for economic data and for general sentiment. Accordingly, the equity market bottomed out:

(click to enlarge)

No sooner had QE1 finished in March 2010, the drumbeat for further stimulus began. With the economy not gaining enough traction post-QE1, a sequel was hinted at just five months later. QE2 was announced in November 2010, to the tune of a further $600 billion of US government debt purchases.

No sooner had QE2 finished, before the drumbeat for further stimulus began (there's a theme here, guys). So in September 2011 the Federal Reserve announced an alternate plan - to side-step QE3 and undertake "Operation Twist" until the end of June 2012. The key difference in this plan was that the purchases of long-term US government debt would be funded by sales of near-term US debt - meaning no need to print money. The goal, however, was the same: to keep interest rates low.

No sooner was the end of Operation Twist envisioned, before the drumbeat for further stimulus began (yep, theme still intact). So now here we are, in September 2012, and off we go once again...back to the future.

<---BACK TO THE FUTURE--->

QE3 was announced yesterday by the US central bank, and follows a similar theme to QE1 and QE2; $40 billion of mortgage-backed securities are going to be purchased each month. But what is different from QE1 and QE2 is that these purchases have been left open-ended; there is no end-date, and they will continue for as long as needed. The Fed also said Operation Twist will continue, while interest rates will remain near zero until at least mid-2015.

This news has been accepted emphatically by financial markets, as it did in response to QE1 and QE2. But let us consider what this means for energyland™ (OIL), and energy risk management. Well, US natural gas (UNG) is doing its own thing, insulated by its own fundamentals. QE3 should have little impact on natural gas, barring its success spurring on higher industrial demand. But for a global commodity such as oil (USO), it means the world. Here is what happened with QE1 and QE2:

(click to enlarge)

Given how we have seen oil react to QE1 and QE2, it is fair to assume that QE3 will have a bullish impact on prices. And this is for a number of reasons:

  • QE3 means printing money, which essentially devalues the dollar. Given the inverse relationship between oil and the dollar, a weaker dollar will likely lead to a stronger oil price.
  • Loose monetary policy (= aiming for low interest rates) means investors look elsewhere to put their money to work.
  • Another symptom of loose monetary policy is higher inflation down the road. And which asset class is considered one of the best as an inflation-hedge? Commodities.
  • Perhaps the most important point: the main aim of QE3 is to stimulate the economy. If it works, we should see rising oil demand.

I hope this summary has been useful. I'd like to leave you with the thoughts of two key figures of our time: Dr. Emmett Brown and Ronald Reagan.

Dr Emmett Brown said "even if your intentions are good, it can back fire drastically." Something to consider as the Federal Reserve promises open-ended stimulus for the US economy.

And finally, as Ronald Reagan said in his 1986 State of the Union address "Never has there been a more exciting time to be alive, a time of rousing wonder and heroic achievement. As they said in the film Back to the Future, 'Where we're going, we don't need roads.'"

We may not need roads, but hopefully QE3 will succeed where QE1 and QE2 have failed, and provide a clearer path ahead.

Source: Back To The Future: What QE Means For Oil