Morning Note - A look at QE2

As far as I can see, the market is currently worried about three things. 

1. The roll out of QE2 and the potential impact that printing money will have on the long term viability of the US economy. 
2. The recent moves by China to increase interest rates and jack up the Reserve Requirement Ratios (RRR) of banks in an attempt to manage growth (and inflationary pressures that go with it) 

3.  Risk of Ireland defaulting on its debt 

1. There are many investors out there that are negative about the roll out of QE2. I don't necessarily share their view although I do say that with some degree of caution given that the longer term impact of such a large program is unknown. In the short term, I think the US had limited options and ran with a program of large scale purchases of Bonds (buying back its own debt) to try and stimulate growth. 

The biggest issue that is hindering potential growth is the structurally high unemployment in the US. I say structurally high because there has has been a structural shift in workforce dynamics in the States. Previously a manufacturing power house it came under pressure from countries with lower cost workers. This was partially offset by a property boom that was built on an explosion of credit. Not because fundamental demand was outstripping supply in the housing market (as is the case in Australia) but because there was a sharp deterioration in lending standards. We all know where this led with the collaterisation of these mortgages and subsequent Global Financial crisis. 

As it stands, job creation remains the key to economic recovery in the US and the manual worker who is now unemployed (about four million) is a key concern. There appears to be little scope for employing these workers unless we see a sharp resurgence in manufacturing. (The cynic in me would say that this is the underlying reason for QE2  - depreciate the dollar to make US exports more competitive). 

QE2 has a goal of reinvigorating growth and like it or not, we are seeing signs that this growth is picking up. The bond market last night seems to be pricing in a higher chance of inflation which occurs because of a pick up in growth (the 10 year bond rose 6% last night to 2.92% - BUY QBE).  

I wrote last week that I think the US has turned the corner and we are starting to see an improving situation (A positive retail sales number last night was an example of this). Confidence is starting to build and I'm getting more optimistic about the prospects in the US, based on the roll out of QE2. There is a long way to go in the US (US core inflation still falling) and there is no doubt there are many unknowns surrounding QE2,  however I think thats its important to understand  positive aspects to the program. It does appear to be working. 

We'll discuss the other two issues throughout the week. 

James Gerrish 
(02) 9375 0117