Sunday, May 19, 2013

Risk Analysis - Quantitative Easing

Is Quantitative Easing (QE) akin to a magnetic suspension on a high end car?  Magnetic suspensions benefit from the selective application of a magnetic field to iron particles suspended in hydraulic oil.  Different settings impact the viscosity of the oil and resulting stiffness or softness of the suspension.  Quantitative easing involves the purchase of government bonds and other assets by the government.  Different purchase programs impact the real (inflation adjusted) interest rate and associated demand and consumption.  Bumpy roads conquered?

There are suggestions that the QE control algorithm may receive an update which will result in a change in asset purchases and eventually interest rates.

Traders and investors would do well to consider the potential impacts, to their holdings, of the next version of QE (QE1, QE2, Operation Twist, QE3...).  Let's briefly look at three possible scenarios:  no change, bumpier ride, and smoother ride using six indicators.  The Federal Reserve and the ECB set interest rates and auto sales and unemployment are a proxy for demand and consumption.  The time periods used in the three scenarios are completely subjective:  

No Change (2012 historic average annual data):
  • Fed rate:  0.3%
  • ECB rate:  0.0%
  • Auto sales, US:  14.5 million
  • Auto sales, EU:  12.9 million
  • Unemployment, US:  8.1%
  • Unemployment, EU:  9.1%
Bumpier Ride (2008 historic average annual data):
  • Fed rate:  1.9%
  • ECB rate:  2.9%
  • Auto sales, US:  13.4 million
  • Auto sales, EU:  13.5 million
  • Unemployment, US:  5.8%
  • Unemployment, EU:  6.0%
Smoother Ride (2006 historic average annual data):
  • Fed rate:  4.9%
  • ECB rate:  2.0%
  • Auto sales, US:  16.6 million
  • Auto sales, EU:  14.8 million
  • Unemployment, US:  4.6%
  • Unemployment, EU:  7.1%
References