Will QE be effective?

Quantitative easing’s main purpose is to provide liquidity to the financial system. A system without liquidity, which we witnessed during the financial crisis of 2008, is one where lending dries up and business is harder to transact.

Back in 2008-2009, the Federal Reserve and other central banks stepped up and provided financial resources to banks to encourage them to lend and thus increase the liquidity of the financial system and the ability to obtain financing.

While the banks held on to some of this money and eventually profited from it, the ability to access such funds increased confidence in the financial system and thus encouraged economic activity.

This was a simple case where the economy had no liquidity and the central banks provided it. We saw a second round of QE in 2010 which unfortunately had some unwanted consequences of driving the U.S. dollar lower and putting upward pressure on commodity prices.

Read: How to read the commodities market

Here we are in 2012 with some investors calling for a third round, QE3. But does the U.S. actually have a liquidity problem right now? Are banks running out of money? Are consumers being turned away at the doors? While you could argue this scenario for some places in Europe, it’s harder to argue that it’s happening in the United States.

QE does not automatically stimulate the economy; it does not affect tax policy; and it does not directly create jobs. These are all things that need to happen in the United States; however, such policy changes should come from politicians rather than central bankers.

This is where we distinguish the difference between monetary policy (interest rate policy set by central bankers) and fiscal policy (revenue and tax policy set by politicians). We have seen very little accomplished by politicians in Washington due to the usual paralysis between the right and left, but it is their policies that are required to help get the United States back on track.

Another round of QE may make some investors happy, but if you inject more liquidity into a system that already has it, the unintended consequences of QE2 (higher commodity prices) could return if it’s not done properly.

TSX back in black

It’s been a quiet August so far. Investors are hunkering down before central bankers and politicians provide us with new headlines to talk about at the end of the month.

Volumes have been low and some investors would highlight short covering to explain some of the trade. However, we saw the TSX break a level last week not seen since May: the year-to-date breakeven barrier in Canadian dollar terms.

Higher commodity prices have helped the TSX achieve such a level, but so has better sentiment out of Europe.

Whether such sentiment is justified is certainly debatable as no new steps to fix the European debt crisis have been taken; however, Angela Merkel made comments in Canada late on Thursday which essentially said that Germany is in line with the approach being taken by the European Central Bank to defend the euro.

Read: Will equity markets keep rising?

Any agreement, no matter how immaterial, amongst two parties in Europe is a victory as far as we’re concerned.

We didn’t see a lot of influential economic data last week, but we would note that retail sales in the U.S. for July were much stronger than expected and the core inflation rate in Canada fell to 1.7%, well within the 1%-to-3% band set by the Bank of Canada.

In earnings news, Dow components Home Depot and Cisco Systems delivered results that the market liked, while the response to Wal-Mart’s results was poor even as the company marginally increased the lower end of its guidance for the year.

While Facebook did not report earnings, it certainly grabbed headlines as some lock up agreements from its IPO expired and the share price fell below US$20.00 for the first time. (Facebook IPOed at US$38.00 on May 17.)

Read: Facebook shares free-fall after lock-up lifted

It was another strong week for oil prices and gold prices were relatively flat, thus explaining the decent performance for the TSX Index and the Canadian dollar which broke through the US$1.01 level for the first time since early May.

Unless policymakers give the market a reason to believe that recent strength is unwarranted, we expect Canadian dollar strength to persist for at least another week.

TRADING WEEK AHEAD

This week is the calm before the storm.

The last week of August we’ll hear from the Jackson Hole Wyoming Economic Symposium. Ben Bernanke is tentatively expected to speak on Friday, August 31 followed by ECB President Mario Draghi on the Saturday.

We’ll then see the European Central Bank meet on September 6, the Federal Reserve meet on September 12-13, along with some Euro finance minister meetings thrown in for good measure.

Combine that with the Republican and Democratic National Conventions and there will be all kinds of noise for the market to digest.

Read: Tune out the noise, invest in North America

Therefore, policy news flow may be quiet this week. We won’t even see much economic data as Canadian retail sales and U.S. Durable Goods Orders will likely receive the most attention.

Normally when markets are quiet on the macro front we can usually find some corporate news to talk about, but that will even be a struggle as most large-cap Canadian companies have already reported earnings (with the exception of the banks) and the list of U.S. companies reporting earnings next week is quite small.

That said, we will see numbers out of Dow Jones Industrial component Hewlett-Packard Co. along with Lowe’s Companies, Dell Inc., Best Buy Co. and Toll Brothers. The current expectation for further monetary stimulus will likely continue to provide support for commodity prices for another week and that, in turn, should help continue the strength we’ve seen of late for the Canadian dollar.

Gareth Watson is the Vice President, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @Gareth_RGMP