November 03,2010

2:15 PM ,Washington Time,the QE2 Moment

By Thomas Wilkins, CFA

At the above time, on Wednesday, November 3, 2010, world financial markets should know how the Federal Reserve Board intends to implement its Quantitative Easing, known as "QE2." The effect on the

U.S. market should be heavily influenced by the action by the Federal Reserve Board. International markets may be impacted as the US dollar may depreciate in exchange markets and other currencies may see increased demand.

 

The Federal Open Market Committee (FOMC) is expected to purchase bonds from the primary Dealers, each of whom have the obligation to bid on at least 5%  of each US Treasury bond auction and are a significant conduit for sale of US bonds. When the FOMC purchases US Treasury debt from the primary dealers, the payment is a credit to the dealers account at the Federal Reserve. This credit is part of the Federal Reserve's ability to create money. As many of the dealers have commercial banking operations, these credits can be the anchor to issue new loans to their banking customers through the 10 to 1 ratio of the 10% reserve requirement.  In other words, each dollar of Federal Reserve credit can multiply into $10 worth of loans to customers in the real world.

 

During the 2008-2009 crises, there was reduced demand for new loans. Also, the Federal Reserve was permitted by new legislation to pay interest on bank reserves for the first time. Also, interest rates paid on these reserves was often higher than very short-term money market rates. The net effect was to improve the liquidity of the financial system, but the normal case-study transmission of these excess reserves into new bank loans was dysfunctional.

 

On November 3rd as in the financial crisis of 2008-2009, the markets should see increased liquidity in the banking system. But as new loans are required to spread these reserves into the real economy, the transmission process of converting reserves to checking accounts is expected to be slow due to the obvious reasons about a slowly growing economy.   The bottom line is:

 

This increased liquidity is expected to show up more in financial markets, especially bonds, gold, silver and stocks than in new loans which are one supposedly objective for improving the economy.

 

Lastly, the short term effect could be just the opposite of the above line of reasoning. Market professional may feel the announced quantities of bonds to be bought by the FOMC may be less than anticipated. Also, the election results may impact the financial markets due to tax issues. However, the long term effects should be greatly influenced by the increased liquidity effects mentioned above and be positive for gold, silver, bonds and stocks. 

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