Archive | December, 2010

The real motive behind QE2

8 Dec

On 3rd November, the US announced Quantitative Easing Part 2. This entailed an asset purchase program of USD 600 bn. The official rational – to lower the cost of long term borrowing. The rational according to me – to pursue a covert policy of dollar devaluation.

The rabbit is out of the hat now. The past few days has seen a rapid increase in the US 10 year bond yields. From 2.9 per cent on 6 Dec, the yields have hardened to 3.22 per cent today. A jump of close to 10 per cent. If anybody had any misgivings about long term interest rates falling post QE2, I hope they are laid to rest.

With Obama agreeing to the extension of tax cuts, markets have factored in a higher federal deficit next year, leading to a sharp rise in yields. Whatever impact QE2 might have had on the long term yields, this one single move has turned the table upside down.

What to watch out for going forward? The value of the dollar. If I was to hazard a guess, the dollar should weaken going forward – fits neatly with Obama’s plan to try and double US exports in the next five years.

In defense of fiat money…

4 Dec

Post QE2, there has been a sharp proliferation in opinion that gold standard is the way to go. The paper money, it is alleged, has brought the world nothing but inflation and debt. Several virtues of gold standard are then highlighted.

I find the scathing criticism of paper money unjustified.

A simple look at the quantity theory of money tells us the following,


where, M= total amount of money in circulation

V = velocity of circulation of money

P = price level

T = amount of transactions in an economy

V is a behavioral constant.

In gold standard, M is inelastic, and given the behavioral constant V, leads to an inelastic P x T. So you don’t get inflation, but you also don’t get rapid growth in an economy as the monetary base M grounds T. T cannot increase rapidly if M remains inelastic as there is a limit to the amount of transactions a given M can support.

In the system of fiat money (paper money), M is elastic and controlled by the central bank. The increase in M (with the V constant at some level), brings a corresponding increase in P x T. Now, how much of this growth is contributed by P and how much by T is very debatable and hence an outright criticism of the paper money system is unjustified.

By making the money supply elastic, we have added to our repository a tool with which to experiment on economic growth. Sometimes, this experiment malfunctions, but suggesting a return to gold standard is like throwing the baby out with the bath water.

Driver for EM Equities?

2 Dec

I read an article on Business Standard (click here) a few weeks back that offers a very nice perspective about the direction Emerging Market (EM) equities will take next year. It tries to analyze the question by looking at the relationship between US monetary policy and EM equities. It goes like this,

1990-1995 : Inverse relationship between US interest rates and EM equities

Low US interest rates drove capital  into EM economies. This was also a period when most Asian economies had current account deficit (CAD) and a leveraged private sector. They benefitted from low US interest rates.

1995 onwards: Relationship breaks down. Direct relationship between US interest rates and EM equities

Asian equities became a function of global growth expectations. Rising interest rates in the US signalled good health of it’s economy, which bode well for global growth and export demand.

So to answer the question what will drive EM equities next year, we need to access whether global economic recovery or loose monetary policy will impact EM more.

If we believe loose monetary policy will be the driving force, its bulls all the way with QE2 nicely lined up. (Capital controls and assets bubbles may be spoilers though)

If we belive do not believe in decoupling, then EM equities are a function of global growth expectations.

And obviously, if we believe, EM economies will successfully align themselves to be driven by domestic consumption, none of the above really matters.

Lets wait and watch.