QE2 Ends – The Dreaded Day Arrives…
As the famed ‘QE2′ enters the final day of its existence, we find that – as ever – markets are moving in the manner that causes the greatest possible angst to the greatest number of consensual speculators.
Irony as a Prerequisite to Executing Speculative Trades:
As we never cease to point out here at greshams-law.com, the challenge of speculation in financial assets attracts vast intellectual resources. So, if one wishes to gain handsomely while only having risked little, one must be thinking (and — indeed — living) in an entirely different way to the herd.
We believe that this concept is entirely valid when it comes to market timing and monetary events. In recent months, people have been watching the events of QE2 unfold with great intensity and scrutiny. So, if one seeks asymmetric opportunities (i.e. those with a favorable risk/reward profiles), then one mustn’t succumb to the mechanistic ways of thought that pervade the financial press these days. That is, one shouldn’t execute trades based on the belief that QE => prices up, and no QE => prices down. Elliott Wave international explained the frivolity involved with this kind of thinking the other day: – in particular, they explained that there is no historical precedent for balance sheet expansions to move with the prices of speculative assets. You can play the video below for the narration of the article, or alternatively read it here.
As mentioned in our recent newsletter, our hunch was that – in spite of the mechanistic interpretation about quantitative easing – risk assets could stage an ironic bounce to mark the end of QE2:
Perhaps it is naive and frivolous to talk about very short-term price action, but I’ll indulge in it for just a moment. The speculative classes have been oh-so-worried about the end of QE2, and this end has been widely publicized and talked-about over the past few months. So, as we have had a fairly long period of mild market stress, it is quite possible that we could have a surprising (and ironic) rally at the end of this month (to mark the end of QE2).
Monetary Matters in a QE-less World:
So, does the halting of quantitative easing immediately and necessarily imply a tightening of the dollar? The answer has to be no. Although central banks certainly have a significant bearing on the path of their currencies, they are also subject to the hopes and fears of market participants. As we explained in our ‘Fiat Currencies trade at Discounts to Par’ series (see here, here & here), the market acts to anticipate future bouts of meddling with money. In short, fiat currencies trade such that they reflect what backs them. In the same way as people wouldn’t (usually) pay more than 1 ounce of physical gold for an IOU on 1 ounce of gold, people don’t pay more than the entirety of the assets of a central bank for the entirety of the liabilities (central bank notes & reserve balances). In this way, ‘fiat currencies trade at discounts to par’ – see below for the current estimate of this discount for the dollar:
To figure out the path of monetary tightening or loosening, we’ll have to keep an eye on the above chart (as well as other similar ones). When we see monetary extremes that contradict market sentiment, then we can be confident that we’re investing with a favorable risk/reward profile.
As tempting as it might be to say that QE2 ends => Markets Down, it is inappropriate to do so. Rather, as Humprey Neill alluded to in the ‘Art of Contrary Thinking‘ (available at the greshams-law.com book store), we should wait until monetary trends cross consensual opinion before executing:
The problem of “money” is far too complex for us to examine in this report. It is a study in itself and one which still confuses the great minds of the world. It would be presumptuous for me to attempt a learned discussion of monetary economics.
However, I do wish to leave with you the thought that, because monetary problems are not comprehended by the public or by the average businessman, “money management” will continually cross up public opinions concerning economic trends.
Monetary manipulation is a crafty and tricky tool within a system of bootstrap economics. If you make it a point to become posted on some of the more common practices of monetary management you will occasionally be able to discern trends that are opposite to those commonly discussed in public pronouncements and business stories.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012