The much talked about and discussed second part of quantitative easing (QE2) will come to an end in June this year. This leaves us with a thought as to whether QE2 really achieved its aim for which it was launched? Besides, it also raises a question as to how the end of QE2 would affect different markets such as commodities, and equity (especially the emerging markets). But before proceedings with all these questions, another important point that needs to be looked at is in case QE2 fails in lifting the global economy, can we expect an announcement of a third series? Going forward in the report, we would certainly figure out the answers for these questions but first, let us explain the background as to why the quantitative easing was needed in first place?

In the aftermath of one of the worst economic crisis since the great depression in US, it was very important for the Federal Reserve Bank (Fed) to elevate the sagging economy. Beginning the recovery process, it used the normal technique and lowered interest rate to boost the economy. However the move to slash rate from 5.25 per cent at the end of July 2007 to virtually zero at the end of December 2008 did little to perk up the economy. Moreover these were the short term rates and targeted towards managing the short term interest rates and so, did not have the desired effect on long term interest rates. Therefore in order to further ease the stance of monetary policy, the Fed purchased substantial quantities of assets with medium and long term maturities to manage interest rates of more than one year. This purchase of assets in a more simplistic term is known as debt monetizing and as an euphuism it came to be known as quantitative easing.

So, it would be apt to say that QE is nothing but a large scale purchase of assets by the central bank. These assets include but are not limited to Treasury securities, mortgage-backed securities (MBS) etc and help in keeping the short to long term interest rates at a lower level. When the Fed buys an asset, it reduces its supply of those securities from the market and because of that its (bonds) prices rise and the yield falls. It is further populated to other securities of similar nature and hence helps in keeping interest rates low. All these discourages saving and inspire firms to invest more, consumers to spend more, banks to lend more and as a results, the economy is expected to come back on the growth track.

Sounds like a perfect dose for an ailing economy to come out of illness!

However if we look at the real picture, the impact of this is not visible. On the contrary, it actually resulted in some unexpected consequences. According to the US Labour Department, during QE2 the number of full-time workers went up by just 700000, from 111.8 million to 112.5 million. Even if we look at the housing market, the situation is no better and as per the National Association of Realtors, the average price of an existing home was USD 177300 in August just before QE2 and currently it is USD 163700, down by eight per cent. The economy that was supposed to fire on all cylinders due to QE2 also faltered and economic growth slowed down from 2.6 per cent at the start of QE2 to just 1.8 per cent for the quarter ended March 2011. So it seems that QE2 majorly failed in achieving its objective of uplifting the sagging US economy and thereby provided a fillip to the global economy. So, what happened to this freshly created money and where did it go?[PAGE BREAK]

The spillover of this easy liquidity could be felt in the equity and commodity markets, which boomed with easy money. It has been observed that there is a strong correlation between the equity market and QE. Since the start of QE2 in the month of November 2010, the S&P index went up by 13.9 per cent (till May 26, 2011) and the MSCI Asia index excluding Japan has rallied 5.5 per cent. If we look at it from the Indian perspective QE2 has not changed much for the Indian equity market, which is down by 12 per cent. The FII inflow to Indian equity markets since November 2010 to April 2011 is only USD 5.6 billion. It clearly suggests that money did not come to the Indian equity market or to other Asian markets and mainly concentrated on the US equity market.

Another place where new money could have been flown to was the commodity markets and QE2 created a massive new bubble in the dollar-based assets. It is clearly visible from the rise in the flow of funds to the commodity markets, which rose to USD 9.61 billion in the first quarter of CY11 compared to just USD 2.77 billion during the same time last year.

This has directly impacted some of the commodity indices. A case in the point is the rise in the S&P GSCI index, a benchmark for investments in the commodity markets and a measure of commodity performance comprising of 24 commodities from all sectors. The S&P GSCI is up by 51 per  cent between August 2010 and April 2011. During the same period Gold is up by more than 20 per cent and silver prices almost tripled. However in early May prices of commodities have softened and one of the reasons for it is the nearing end of QE2. This also reflects that market is not expecting any third round of quantitative easing and accordingly adjusting their portfolio. Besides, large scale monetization of debt will ultimately lead to higher inflation and interest rate, which is not desirable for the corporate and hence stock market. So, it is extremely unlikely that we will have QE3.

We also believe that from the Indian equity market perspective the end of QE2 will bring some respite. The reason being, since Indian markets have not received much of the money from QE2 we should not be worried about the outflow of FII money. Moreover it has also been observed that easy and cheap money has tempted fund managers to take exposure to riskier assets like commodities and these are likely to get reversed with the end of QE2. The primary beneficiaries of this will be emerging economies such as India, which is available at attractive valuation. In the month of November 2010, the BSE 500 was trading at PE of 23.84 times and currently trading at 18.03 times. Moreover, if Q4FY11 results are anything to go by, India Inc has continued its momentum and topline & bottomline have increased by 22.4 per cent and 17.87 per cent respectively.

Additionally, the end of QE2 would help the Indian equity market in different other ways. First and foremost, the outflow of money from commodity markets will bring down the commodity prices as has been witnessed in the month of May (S&P GSCI is down by 11 per cent). This will help to bring down inflation and reduce the pressure on interest rates. In addition the end of QE2 will also somewhat correct the misallocation of funds and emerging markets like India, which are still growing at rate of eight per cent, will attract more funds.