Much has been written over the course of the last few days/weeks about what Bernanke could do, has done, and the efficacy of said actions. Inflation, unintended ‘energy’ consequences, debasement, financial repression, scarcity transmission mechanisms all come to mind but realistically they are all just symptoms of what is really going on. As the following chart from Barclays shows, the real effect of LSAPs is to suppress the signaling effect of macro data from the real economy. During periods of extreme monetary policy, the stock market’s beta to macro-economic data surprises is dampened massively – and hence the forced mal-investment and mis-allocation of funds occurs. However, given the now open-ended nature of QE3, this may change with the ‘good news/bad news’ logic leading to a stronger market (higher beta) response (since all bad news is automatically attenuated by QEternity and thus all the good news is out there).
An important driver of this attenuated market response to economic news was the sense that important elements of the monetary policy framework were ‘in play’, and that policy was likely to respond if the economy weakened sufficiently, but not otherwise. In this context, bad economic news may not seem so horrible, if it is perceived to raise the probability of a market-friendly monetary policy response. In the run-up to June 2011, the question facing investors was whether the Fed would allow QE2 to end in June, in accord with the Fed’s stated intention. More recently, the question has been whether the Fed would put a more aggressive policy in place. But the ‘good news/bad news’ logic was much the same.
It seems to us that this logic will not, however, remain operative in the months to come, since the policy frameworks recently announced by both the Fed and the ECB have no stated end date on which markets can focus (as did QE2), and are not likely to be materially adjusted in response to economic data for some months to come. Economic news may have been a ‘good news/bad news’ story in the recent past. But now that the monetary policy responses to economic weakness are in place, markets have had the good news.
In the future, bad economic data will be, well, just bad, and good news will be unambiguously positive. This should lead to a stronger market response to economic data in the weeks and months to come.