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QE2 Sugar Rush May Be Over

Kevin Kiefer
Economics/Finance Major
Gettingmarketmoney.com Market Analyst

Won't QE2 continue to boost asset prices?


This latest rally since the start of September has been based on a house of cards. As we said last week, we were likely to start a new trend to the downside in the equity markets this week and a new uptrend in the dollar. Today, we got exactly that. The S&P finished down more than 1.5% and the dollar rallied 1.7%, a huge move in the currency markets. We also told you to short gold if you wanted to really take some risk and get some alpha, and we got that today as well. The gold market finished down 3%. Some of you are probably thinking why did gold go down with the market? Wasn't gold suppose to rally because of fear? No. Every asset class has been rising since September 1 because of the belief that the fed will pump another trillion dollars into the economy via a second round of quantative easing. However, as we said last week, the markets have likely already priced in QE2 and unless QE2 can boost the economy, the equity and commodites markets are likely to go much lower from here. There are many reasons why we think QE2 will not boost the economy.

  • The first round of quantative easing has done nothing to help employment. While interest rates have went lower, this money is not being used for investment in the economy and therefore you will not have a strong labor market.
  • You can't borrow your way out of a credit bubble. Interest rates can go lower, but the aggregate demand for loans will not go up. At this point, people are forced to save more and deleverage.
For these reasons, we believe QE2 can only boost asset prices in the short run before a decline occurs in the stock markets. You can compare it to a sugar rush you get from an energy drink. You get a boost at first, but then when it's gone, your worse off. Quantative easing is similar.

Aren't the banks in healthier shape? Isn't the foreclosure crisis almost done? Hasn't the housing market found a bottom?


The simple answer is no. Banks have been able to hide a lot of their toxic assets because of the new accounting rules. The foreclosure crisis is not even close to being done either. Unemployment has been hovering around 9.5-10% for months now and more and more people are falling behind on payments. The real unemployment ( including underemployed and discouraged workers) continues to climb. Without significant income growth and employment growth, people will continue to default on their loans. This also puts downward pressure on the housing market as supply increases. If home prices start falling again, there is a massive amount of loans that would go underwater (when the house value is less than the loan is worth) and you could easily have a second downturn in the housing market, even with low interest rates. Now, we are not forecasting a huge decline in housing from here because it is impossible to know exactly how supply/demand forces will play out over the next year. We are simply pointing out the fact that their are huge problems still in the banking system and our housing market that are not likely to get better in the short term.

The labor market had a slow start coming out of the 2001-2003 recession, why won't the labor market pick up in 2011?

The labor market is not likely to improve anytime soon. Coming out of the 2003 recession, we had the housing bubble that added many construction jobs and people's wealth increased which increased aggregate demand in the economy. The savings rate continued it's decline that started in the early 1980s and also added demand in the economy. This is why the labor market picked up coming out of the last recession. This time is different. Most recessions in the US have been lead out by housing, but given the fundamentals that is highly unlikely this time. Also, the US consumer is tapped out and must increase savings and pay down debt, pulling aggregate demand out of the economy. Unless companies see the US consumer in a better position, they are unlikely to invest and create jobs in the US. And since it will take the US consumer years to get out of the mess they got themselves in, the labor market is unlikely to get better any time soon. Even if all the bush tax cuts got extended, this is unlikely to spur job growth based on the reasons stated above. However, extending the bush tax cuts for the lower and middle class could help the deleveraging process that needs to occur for these people that are in debt.

So where do we see the markets going from here?


As we said last week, all markets from gold to oil to equities to junk bonds were overbought and we were likely to see a trend change this week. Today was turn around tuesdays with all of these markets mentioned above starting this down turn we were expecting. With this being said, because of the huge move down in gold and move up in the dollar, it is possible that we see a few days of gold retracing some of that move down and the dollar filling in some of that gap. This may cause stocks to turn up slightly for a few days as well. However, we firmly believe that we have entered a new trend to the downside for equities and commodities. With China raising interest rates, this will only put more pressure on these markets. We would use any bounce in equities and gold over the next day or two to sell and any weakness in the dollar to buy. We will then wait to find the next short term bottom in stocks to buy and try to trade around this market, even though we believe the trend will be down for stocks.

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Disclosure: Long "UUP"