Fed QE Round - Raising inflationary expectation

Many market pundits believe they wouldn’t do it. But they finally did it. Though many believe that it was unnecessary, there is this notion that the FOMC was under tremendous political pressure to "do something!" So the Federal Reserve decides to expand its holdings of longterm securities, namely buying US$40b of mortgage backed securities (MBS) a month for the foreseeable future. Its objective is to stimulate the economy, primarily by artificially suppressing  mortgage rates, which in turn they hope will stimulate the housing market and thus contribute to a stronger economy. 

Given the less than sanguine impact of its two predecessors – QE1 and QE2 - the impact of this third round of quantitative easing will comparatively be less. In the short run, QE3 might  give a little boost to asset prices, such as stocks and commodities. Surely owners of stocks, precious metals and other essential commodities will not complain about that. Unfortunately, to judge by key market-based indicators, all they have achieved so far is to stimulate inflation expectations. Hence, it may seem natural to conclude that "easy money" causes commodity price spikes.  

However, that may not be the case today as the fundamentals of the oil market look pretty bearish. The economic slowdown in China has removed that country as a major source of oil demand growth. Meanwhile, U.S. petroleum product imports have reliably been declining year over year. Indeed, with the busy summer travel season having just ended, oil demand is likely to  tail off dramatically. Though a geopolitical flare-up in the Middle East could quickly change the supply picture, medium term oil prices outlook seems to show a downside of 20% or more. Hence, we are maintaining our crude oil forecast of US$93/barrel by end of this year and possibly a marginal increase of US$96/barrel by end of 2013.

The FOMC also mentioned that it would probably hold the federal funds rate near zero “at least through mid-2015,” adding that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” Since early this year the Fed had said the rate was likely to stay low at least through late 2014.  As the Fed has moved its indicative interest rate target further forward, it reaffirms our view that Malaysia’s Bank Negara would not change its monetary stance for the rest of this year and the next. Hence, barring unforeseen circumstance, we expect the OPR to remain unchanged till 2014.

Based on previous QE, the side effect is that it would weaken the dollar. Therefore we believe that the ringgit will experience a short term boost and will appreciate in tandem with the regional currencies.  Against the dollar the ringgit is currently at 3.08, an appreciation of about 3.5% from around 3.19 in early July. Over the next few weeks, we expect the volatility in the currency market to increase which may see the ringgit testing the 3.00 level. Given that Malaysia is still susceptible to external demand, we are maintaining our year-end ringgit forecast of 3.10.   

To conclude, at worst, QE3 will have minimal effect; at best, it might keep the US economy from falling back into recession. Given that the QE3 may give some short term booster to the US economy, we are maintaining our GDP forecast for 2012 at 5.0%.

Source: Kenanga