q.e. and its waning power

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Between March and November of 2009, the MPC authorized the purchase of £200 billion worth of UK financial assets, mostly UK Government debt or “gilts”.  The MPC voted to begin further purchases of an additional £75bn in October 2011 and, subsequently at its meeting in February 2012, the Committee decided to buy an additional £50bn. In July 2012 the MPC announced the purchase of a further £50bn to bring total assets purchases to £375bn.” So says the Bank of England Website.

Now, we all know what happened in 2009. The onset of Quantitative Easing (QE) in the UK and US drove one of the largest equity market rallies ever seen, particularly in risk assets.  Some small companies that were priced for bust improved over 1000% in just a few months! However, this initial  burst of QE was £200bn. Since then, the amounts of £75bn and £50bn have not quite had the same effect. In the Bank of England’s theory, QE should provide a direct boost to share prices and so to the wider economy. The question I wanted to know was how much of an effect and over what time period does it last? That way, I would find some guidance as to the potential quantum of market gains we can attribute to QE and so what might be the de-rating effect as and when it is finally withdrawn by the “Old Lady”.

Also, there is the issue of the correlation of risk assets versus safe assets. For the purposes of this blog I have attached the charts of both the AIM index and the FTSE100 index, broadly representing risk on and risk off for UK investors.

So what does this show us? Well, firstly that the £200 billion of QE had a huge impact (no doubt as this was new, relatively unexpected and came about in an environment of extreme pessimism – in other words an atmosphere ripe for positive catalysts) but, remember also the markets were much lower and valuations more depressed. As the markets have recovered, and the incremental QE amounts have been lowered, the bounce has already been retraced by around 30% from the peaks in the AIM index, whilst in contrast, the FTSE has held onto the majority of its gains. Interestingly though, the Feb 2012 injection correlates with a decent sell off in the markets – not quite what the BoE expected…

So what for this latest July boost.? Well, I suspect the impact will be to push the market higher given the normal low volumes in the FTSE 100 during the summer. However, the correlation with AIM is pretty broken and I can’t see why this will suddenly reverse – the risk-off mentality in AIM must be being driven by stronger macro factors such as the Eurozone crisis.

So then, the million dollar question is what will happen when the interest rate cycle finally turns and QE is withdrawn – the mirror image is that we could face a pretty hefty give back in the FTSE 100 in particular although it has to be said that given the economic woes we currently face that we are likely at least 18 months from this point.

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