Springheel Jack’s post yesterday (UUP Breaks Up) got me thinking about the correlation between the dollar (UUP) and the S&P. Apparently, Tim was thinking along the same lines this morning with his Forex post (The Euro and the ES). I am trying to look at the long-term picture of what/how the various Fed “efforts” have moved the market. The story of [Ben turns on the presses = goosed market] is already known, but I’m looking to determine the extent of the correlation during the different periods.
Quick history: In late November 2008, the Fed started buying $600 billion in Mortgage-backed securities. By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010. After a relatively short break and a coincidental 20% drop in the market as QE1 ended, the Fed decided to renew quantitative easing because “the economy wasn't growing robustly”. Its goal was to keep holdings at the $2.054 trillion level by replacing maturing debt. To maintain that level, the Fed bought $30 billion in 2-10 year Treasury notes a month. In November 2010, the Fed announced it would increase quantitative easing, buying an additional $600 billion of Treasury securities by the end of the second quarter of 2011.
The correlation between UUP and the SPX since March 2007 is -.35; not exactly investment-worthy in my book. However, I broke out the correlation during the aforementioned periods:
Pre-QE -.27
Since QE1 started -.83
During QE1 -.68
Between 1&2 -.94
During QE2 -.67
A couple things jumped out at me here… First, that since QEs started, the market now dances to the Fed’s tune (duh); but more importantly, the correlation data says it is by a significant- and therefore investable- amount. Second, the -.94 is a surprisingly extreme number… it was only for a 4 month period, but I cannot say with any certainty why. I would imagine that by not knowing if there was going to be a QE2, traders followed Forex more closely. On the other hand, the Forex and equity markets could have been reacting to, as I recall, a tremendous amount of chatter back then speculating that QE2 was coming.
Now that QE2 has “ended,” I bring up these points because in a speech to Congress, Bernanke said the Fed is preparing for another round of Treasury bond buying (y’know- just in case this “soft patch” isn’t as temporary as Washington would like voters to believe) and the QE3 chatter seems to have increased (e.g., Why Bernanke And Pals Will Soon Need a New Pair of Pants, Stocks Rise Amid Hopes for Further Stimulus).
I’m neither an economist nor a political commentator, but with an election next year, I think they will throw everything they have at keeping the market propped-up… including some creative way to implement QE3. So, if recent history is any indication, we should now be in a period similar to the one between QE1 and QE2; where there is a high inverse-correlation between the dollar and the market.