Last week’s surprise move by the Federal Reserve to buy $300 billion in long-dated bonds and effectively start printing money brought a sharp fall in the US dollar, and a strong bounce in oil and gold prices.
Is this the story of things to come? Pimco CEO Bill Gross, the bond king says the Fed may need to expand its balance sheet from a projected $2-3 trillion to $5-6 trillion to get the economy moving again.
This is a slow motion process. The more immediate impact, apart from lowering the cost of borrowing, is a lower dollar. Then by 2011 or so Mr. Gross sees the return of inflation, and is buying inflation-protected bonds called TIPS - which also jumped in price last week.
For Middle Eastern investors in particular this scenario has important implications for the oil market: a lower US dollar generally means a higher oil price. Remember it was dollar weakness that helped to drive oil prices to $147 last July, and dollar strength popped that bubble (see graph above).
But hold on a moment, how are stock prices going to react to quantitative easing or money printing by any other name? Last week the 20 per cent rally in the Dow Jones stopped and reversed on news of the Fed’s action.
The US stock market will be nervously watching statements this week for more detail of the Fed and Treasury’s plans. However, if you look at share valuations then they are back to the lows of 2003 and that hardly appears low enough for the profit depression now certainly ahead for major companies.
Now what happens if shares sell-off again, perhaps in a probably not unjustified panic about the three-year outlook for profits? Then the dollar will rally, precisely as it did last autumn, because stocks will be sold for cash, increasing the demand for the dollar.
That would lower oil and gold prices, just like last autumn. So it might still be too early to go back into stocks, and even to abandon US Treasuries. For there is another down leg in the stock market to endure before such a shift should be considered.
All the same, with inflation definitely on the horizon - albeit at some distance - oil and gold will eventually come out on top, and may not suffer as much in the next bear market down shift.