Some more observations on what will be the most contested capital markets topic through November 3. Goldman's Sven Jari Stehn has attempted to do quantify the response to the question that most equity and bond investors are banging their heads over: namely, how much of QE2 is already priced in. Goldman's findings: "a purchase program of about $1tr may now be reflected in 10-year Treasury yields, the three-month Libor rate and the dollar." Of course, there is a qualification: "This finding, however, is sensitive to when we think the market started pricing in QE2; equity price gains since Bernanke’s Jackson Hole speech have been more pronounced." Then again, there are those who will say that using QE1 as a framework for any comparative efforts is useless, as QE1 had little to no effect. While that may be true for the general economy (read Main Street), it certainly helped liquidity conditions on Wall Street: "our estimates suggest that “QE1” eased financial conditions significantly through lower long-term yields, higher equity prices and a weaker dollar." In other words Wall Street and Corporate America 1, Everyone else 0. But we knew that long ago. So here are Stehn's full findings, which may disappoint all those who are hoping for the absence of a sell the news event at 2:15 pm on November 3 (and will certainly disappoint all those who are hoping there will be no broad flash crash if there is no news): in a nutshell double the upcoming $1TR QE2 is already priced in in bonds, and half of it: in equities. Using such Columbia Business School-approved scientific methods as law of averages, Gaussian distribution, and pig vomit, which serve as the basis for every flawed economic theory, this means QE2 is now fully discounted.
First, in "QE2: How Much Has Been Priced In?" Stehn attempts to quantify the impact of QE1 on Wall Street bonuses as determined by such much less relevant factoids as bond spreads, and equity levels.
The Federal Open Market Committee (FOMC) is widely expected to announce renewed asset purchases at its November 2-3 meeting. We regard an initial announcement of $500bn as likely but anticipate that the size of the purchase program will ultimately total at least $1tr.
The experience with the first round of asset purchases suggests that “QE2” could have substantial effects on asset prices. Although the uncertainties are huge, our estimates suggest that “QE1” eased financial conditions significantly through lower long-term yields, higher equity prices and a weaker dollar. (See “Unconventional Fed Policies and Financial Conditions: How Tight a Link?” US Daily Comment, August 17, 2010.) Given the difficulty of identifying the quantitative effects of asset purchases we estimated the effects on financial conditions over three different horizons (we considered 1-day changes, 30-day changes and a permanent “levels” effect). The average across these three horizons suggests that financial conditions—measured by our financial conditions index, GSFCISM—eased by around 80 basis points (bps) per $1tr of announced purchases (see first part of the table below). This easing in financial conditions is due to a 49bps decline in long-term yields (contributing 27bps to the decline in financial conditions), a 7bps reduction in the three-month Libor rate (worth 3bps), an 8% boost to equity prices (40bps) and a 2% dollar depreciation (10bps). We further found that the 10-year Treasury yield fell by around 25bps per $1tr of announced purchases, suggesting that roughly half of the decline in the long-term yield—which is the sum of a 10-year swap rate and a 10-year credit default swap spread—was due to a narrowing of spreads.
Next follows a pretty table that argues convincingly that anyone who made a bonus less than $1 million last year must run a Fund of Funds and appear constantly on Fast Money:
And now, for the main attraction:
How much of QE2 has already been priced into the markets? This is a difficult question and any answer is necessarily subject to enormous uncertainty. Nonetheless, we can use our estimates above to form a broad view in two steps:
First, we choose a date at which the market most likely started to price in additional easing. Two candidate dates come to mind. First, August 3, the day a Wall Street Journal article suggested that the Fed was about to set course for additional easing through the reinvestment of maturing/prepaid mortgage-backed securities (MBS). Second, August 10, the FOMC meeting day at which the MBS reinvestment decision was subsequently taken.
Second, we go on to compare our “average” estimates of the effectiveness of QE1 with the observed changes since these two dates to form a view on how much of this easing was driven by the expectation of QE2—on the working assumption that the market expects additional asset purchases ultimately to total $1tr.
Before turning to the results, it is worth highlighting the limitations to which an approach as simple as this is subject:
First, it is debatable when the market started pricing in QE2. The week between the August 3 Wall Street Journal article and the August 10 FOMC meeting—which also included our own August 6 call that we expected to see unconventional easing, probably with at least $1tr of additional asset purchases—appears the most reasonable choice. An alternative would be Fed Chairman Bernanke’s August 27 speech in which he laid out the Fed’s options for additional easing. The choice clearly matters for any view of how much the market has moved since then in anticipation of QE2. Equity prices, for example, are currently only 3% above their early August levels—but more than 10% above their end-August reading.
Second, our estimates of the effects of QE1 are sensitive to the time horizon under consideration. In particular, our models suggest that the equity and dollar effects build over time; for example, while we found no effect on equity prices on the day of announcement, the S&P appeared to have risen strongly after 30 days (the 30-day change and permanent “levels” effect equal +10% and +14% for a $1tr announcement of asset purchases, respectively).
Third, we compare our estimates of the effects of QE1 with actual changes in asset prices and thus do not take into account the influence of other asset-price “drivers.” For example, the direction of moves in Treasury yields in August could have reflected either expectations of QE2 or the impact of weaker-than-expected data on market perceptions about the economic outlook. This, in turn, would make it difficult to disentangle one cause (QE2) from the other (economic weakness). However, the September data mitigated this problem, as markets continued to behave as if QE2 was likely despite a better-than-expected run in the data.
With these caveats in mind, we draw three conclusions from the table:
First, the basic pattern of market moves is broadly consistent with growing anticipation of additional QE. The middle part of the table shows the actual change in the GSFCI components and the 10Y Treasury yield since early August. We see that financial conditions have eased substantially due to movements in all four components: lower ten-year Treasury yields, lower short-term rates, higher equity prices, and a weaker dollar. The lessons of QE1 have thus been mirrored in the anticipation of QE2.
Second, while guessing the magnitudes is hard, the size of these asset price moves suggests that markets have moved quite far toward pricing the kind of program we expect. In particular, a purchase program of about $1tr may now be reflected in 10-year Treasury yields, the three-month Libor rate and the dollar. Spreads—defined here as the difference between the synthetic long-term yield in the GSFCI and the yield on ten-year Treasuries—have contracted less than suggested by the first round of purchases, at least so far. (This might not be surprising given that spreads are much narrower going into the second round of purchases than the first.) Similarly, equity prices have risen less than the experience with QE1 would suggest. This finding, however, is sensitive to when we think the market started pricing in QE2; equity price gains since Bernanke’s Jackson Hole speech have been more pronounced.
The view that the market has at least gone some way towards pricing in QE2 is consistent with a recent poll conducted by our fixed income sales team. This survey polled 59 clients to find that 50% of participants expect more quantitative easing with an average amount (over all participants) of $500bn. (This survey was conducted on September 21 prior to the last FOMC meeting and the recent speeches by Fed Presidents Dudley and Evans, both of which signaled a high likelihood of QE2 as early as November. One would expect that participants’ expectations have risen in response to these events.)
Finally, the experience of QE1 is that the impact on assets tended to grow over time, even some time after the announcement. This suggests that even after the moves seen to date, these trends could extend in some places. Consistent with this conclusion, our market group expects more dollar weakness and moderately more S&P upside
In other words, plugging in a whole lot of data the Stuxnet 3000 recombinator prints out a matrix sheet which confirms that almost $2 trillion worth of QE2 has been priced in, while roughly $500 billion of discounted easing has already boosted stocks. Which means that should the Fed not announce QE2, or do some weak, BOJ-style piecemeal intervention with price-targets, that stocks will lose all their gains since early August, and bonds will collapse. So will commodities.
Then again, since the Fed controls the capital markets on the front and back end, all of this is irrelevant, and you just wasted 10 minutes of your life reading about the one outcome that will most certainly never happen.