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The stock market keeps rising "as if propelled by some mysterious force," Tuesday's Wall Street Journal quotes one incredulous analyst. Equities are indeed being pushed higher by an inexorable force, but one that's no mystery -- money.
The U.S. stock market's total value has increased by over 25% -- some $3.2 trillion -- since Aug. 26, based on the Wilshire 5000, the broadest measure of the market. That date was prior to Federal Reserve Chairman Ben Bernanke's speech to the central bank's Jackson Hole, Wyo., policy pow-wow, when he first laid out the justification for the Fed's purchases of Treasuries now known by all as QE2, the folks at Wilshire Associates remind us.
That's not a bad payoff, especially considering the Fed is less than half way through the program to buy up to $600 billion of Treasuries by the end of June. Too bad that bond yields and mortgage interest rates actually are higher since QE2 departed its slip, but that falls under the category of collateral damage.
As Bernanke explained in an op-ed piece in the Washington Post on Nov. 4, the day after the Federal Open Market Committee formally approved QE2, "higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending."
This so-called wealth effect, of course, is confined to those invested in equities, who tend to shop at Saks (ticker: SKS) and Tiffany's (TIF). The inverse, which one supposes should be dubbed the poverty effect, is felt by those who have to pay higher prices for fuel and food that have followed the Fed's liquidity expansion from its Treasury purchases. Stores that cater to hoi polloi have seen sales fall short of projections, leading to labored performance for their stocks, as Michael Kahn's Getting Technical column points out.
Another effect of QE2, observes RBC Capital Markets, is that "the Fed is now far and away the biggest buyer and holder of Treasuries," at well over $1 trillion. As a result, the federal government is able to finance its budget deficit effortlessly, as the Fed effectively buys as many securities as the Treasury sells.
It also means the Fed thus has supplanted China as the largest holder of U.S. government debt, which is not an unalloyed advantage to America. True, one arm of the U.S. government is creditor to the U.S. government. But it means that the debt is being monetized -- paid for by money that is figuratively printed but literally conjured out of thin air.
Which is just as well, since China has been paring its holding of U.S. government securities. According to the latest Treasury International Capital data released Tuesday, China reduced its holdings of Treasury securities due in one year or less by over $21 billion in November, the month that QE2 launched. While China boosted its holdings of Treasuries due in more than one year by $10 billion, the yield on the benchmark 10-year note started its ascent in earnest, to over 3.50% in mid-December from under 2.50% at QE's launch in early November.
Even though it has been supplanted by the Fed as the No. 1 holder of Treasuries, China's role as a supplier of global liquidity remains considerable.
As a result of its purchases of Treasuries, which swell the balance sheet of the People's Bank of China, the nation's central bank, China's M2 money supply has exploded by 148% from January 2007 to December 2010, to $11.2 trillion from $4.5 trillion. U.S. M2 has expanded "just" 25%, to $8.8 trillion from $7.1 trillion over that span. Those revealing numbers are brought to light by International Strategy & Investment, headed by the lynx-eyed Ed Hyman.
The irony of all this is that as President Obama meets China's leader, Hu Jintao, their respective monetary policies will be the key point of contention. Not the usual topic of conversation among world leaders, but one of crucial importance to heads of the No. 1 and No. 2 nations in economic terms.
The U.S. accuses China of keeping its currency, the renminbi or yuan, undervalued -- which it does by buying Treasuries with dollars bought up with yuan. China says the dollar-centric international monetary system is an artifact of history and the greenback no longer is a reliable store of value because of American monetary and fiscal excesses.
Expansionary U.S. monetary policy is necessarily imported by China as long as it effectively pegs the RMB to the dollar; excess greenbacks are bought by China, which prints RMB to do so. Chinese monetary authorities are attempting to offset the exchange-rate effect on monetary policy by raising bank reserve requirements and interest rates. China's stock market reflects this move to a less easy policy.
The Fed, for its part, will almost certainly complete its QE2 purchases of $600 billion. The question becomes, then what? A sticky unemployment rate will boost pressures for QE3, even if it is a smaller vessel than QE2.
Or will the inflationary consequences of massive money printing on both sides of the Pacific induce central banks to change courses? In developed economies, higher food and fuel prices mean reduced discretionary incomes and curtailed spending on other items. In developing countries, price hikes for food already is sparking riots.
For now, money printing is the mysterious propellant for stock prices. How long it lasts until it fizzles is another question.
Comments: E-mail randall.forsyth@barrons.com
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