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QE Correlation Does Not Imply QE Causation


The markets are much more sophisticated than the basic cause and effect analogies that constantly bombard investors.

Following this week's FOMC meeting Chairman Bernanke held a press conference to allow members of the financial media to ask questions about the direction and efficacy of monetary policy. Chairman Bernanke has tried to increase transparency by providing more communication of monetary methodologies and intentions, however the members of the media have failed miserably at extracting information that is not already spoon-fed to the markets. This past week was a glaring example of how inept and downright negligent the financial media has become in evaluating Fed policy.

The line of questioning can be categorized in four basic subjects: the remaining duration of QE, too big to fail, Cyprus, and Bernanke's tenure as Chairman. There were a few outlier questions but basically all addressed these matters.

The first three questions from the Washington Post, Financial Times and CNBC all pestered Bernanke about when the Fed would exit from QE. The Wall Street Journal's Fed reporter, deemed Fed leaker by many in the market, lobbed in a softball question about what the Chairman planned to do after his term is completed.

Fox Business News asked if it was too late to get long stocks and whether Bernanke considered it mission accomplished. Shockingly Bernanke entertained this idiocy by responding that "we're not targeting asset prices or measuring success in terms of the stock market," but if we were, "we don't see at this point anything that's out of line with historical patterns."

Aside from these few questions that skirted with an intelligent debate, the press conference was a complete waste of time. Honestly I don't understand why the major media outlets, and frankly the Street's research analysts, can't better frame the debate. There are much more important questions that I would like to see answered such as the following:
Mr. Chairman:

How does QE lower bond yields when at the margin the Fed doesn't represent any larger source of demand than they have historically?

If you believe that it's the stock that matters and not the flow then why did you need to continue QE with interest rates already so low?

Is your unemployment rate and inflation target a de facto nominal GDP target?

From what year do you extrapolate the output gap, and assuming your 4.0-4.5% implied nominal GDP forecast, how long will it take to close it at that growth rate?

Why does the velocity of money continue to collapse, and is it because the capacity of the banking system is too large to support the demand for credit?

With banks increasing their allocation to securities in lieu of making loans, isn't the banking system's interest rate risk exposure just as high as its credit risk exposure before the financial crisis?

Does devaluing the global reserve currency risk alienating our foreign lenders which we desperately depend on to finance our deficit?

The problem lies in the universal belief in the Fed's omnipotence. Without actually investigating participants, just accept the fact that the Fed's actions are responsible for market activity. The Fed has launched this radical quantitative easing, injecting trillions into the banking system by purchasing bonds, and at the same time bond yields are falling and stock prices are rising, therefore QE is responsible for driving market prices. It's virtually an undisputed fact. But is it true?

Instead of taking their word for it, let's examine the actual numbers as QE pertains to the Treasury market. Depending on the maturity the Fed is buying up to $5 billion Treasuries per day. It is estimated that the cash market trades approximately $500 billion per day in bills and coupons with between $250 and $300 billion traded in maturities over three years. The Fed is buying an amount equal to 1% of the total daily cash volume and roughly 2% of volume in the longer maturities. If the Fed didn't announce what they were doing it would likely go unnoticed.

Some (including the Fed) might argue that QE is continually reducing the outstanding stock of Treasury supply, therefore exerting downward pressure on yields. But as I argued in Quantitative Easing: The Greatest Con Ever Sold, the Fed's holdings are just keeping up with the increasing supply. They are just maintaining the same ownership as a percent of outstanding stock as they have historically. At the margin they do not represent a larger source of demand than they have in the last 50 years.

Think about it this way. If the Fed was buying a like amount of Apple (NASDAQ:AAPL) stock as they do in cash Treasuries, they would be buying 180,000 shares per day in a stock that trades 18 million. At the same time AAPL would be issuing 9 million in new shares per year. Would the Fed buying 180,000 shares a day have any influence on AAPL's price? I think most would agree that just because AAPL is rallying and the Fed is buying doesn't mean AAPL is rallying because the Fed is buying.

One of the most fundamental rules in statistics is that correlation does not imply causation. It's a fallacy. Just because two variables look to be related doesn't mean they are. Yet it seems the entire financial economy is built on this false presumption. Everyday you can turn on the financial news, read the paper, read an analyst report or find it in the blogosphere. Take last Friday as an example. Saturday's Wall Street Journal:
US stocks gained ground Friday, nearly erasing the week's losses for the Dow Industrials (INDEXDJX:.DJI) as investors started to look past the latest eurozone debt drama.

The day before when stocks were down it was the opposite. From on Thursday:
Stocks finished in negative territory Thursday, dragged by techs, amid ongoing concerns over Cyprus' ability to get a bailout.

There is way too much reliance on the assumed cause and effect. The news from Cyprus was bad, and stocks fell, so Cyprus caused stocks to fall or conversely stocks rose so stocks are looking past Cyprus. This is ridiculous.

It's the same with the Fed and QE. First it was that stocks were rallying as the Fed was trying to reflate assets, therefore stocks were rallying because the Fed was reflating. Now stocks are rallying to new highs and bond yields are rising so the markets must be responding to an improving economy. Thus a great rotation out of bonds and into stocks is underway.
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