My thoughts on QE

I thought I'd do something different and post my thoughts on QE, what it is and how it effects prices of stocks and bonds. It will be a round up of my thoughts after reading up on the subject in the blogosphear and some links where these thoughts are expressed more in detail.

What QE is

QE is an asset swap. Under the current scheme FED gets treasuries and MBS’s (Mortgage backed securites) and in exchange the banking system gets excess reserves and cash. For banks it means more liquidity but lower yielding assets. The FED gets added income but added risk.

What QE isn't

QE is not printing money that goes to buying stocks.

Why Quantitative Easing Isn't Printing Money

QE only results in FED reserves and cash, so far about 80% of QE is new reserves, 20% is new cash.

http://www.washingtonsblog.com/2013/06/81-5-of-money-created-through-quantitative-easing-is-sitting-there-gathering-dust-instead-of-helping-the-economy.html

QE will not cause credit expansion because reserves are not used for making new loans

http://pragcap.com/sp-says-repeat-after-me-banks-cannot-and-do-not-lend-out-reserves

Is QE inflationary?

Yes but only marginally. The value of money is determined by the fundamental value (Assets of the FED) plus its liquidity value (The premium over its fundamental value for any asset that is liquid). QE drives out the liquidity value of money and makes its value close to its fundamental value.

For more on understanding fundamental value and liquidity value of assets:
http://jpkoning.blogspot.se/2013/08/google-as-monetary-superpower-parable.html

Do QE cause stocks to rise in price?

Stocks by empirical observation have risen from QE, at least initially. Does QE drive other money to buy stocks? Before QE the private sector owned more treasuries and MBS’s that yeilded higher returns than FED reserves. To get the same yeild in total after QE a rebalancing must occur to assets width higher yields when so much assets are locked in low yielding/low risk reserves. This might be one reason more stocks will be demanded.

What effect do QE have on bonds?

By empirical observation QE puts downward pressure on bonds.

http://seekingalpha.com/article/1447181-to-sustain-the-rally-the-fed-should-start-tapering-now

What's a possible explanation? The only one I've seen so far is that QE appart from being mildly inflationary, raises inflation expectations. Then this reaction in the bond market would be irrational. Another reason could be the same as the one for stocks. The private sector wants higher yeilding assets than bonds since they've just been forced to hold plenty of low yielding assets in the form of reserves.

Conclusion

QE is an asset swap, its affect on overall inflation is small and decreasingly effective the more it is done. Its effect on stocks and bonds might be that it drives banks into rebalancing their non reserve assets to higher yielding assets.