FOLLOWUP: Interestingly, the announcement of Operation Twist had unforeseen and unintended short term consequences. Within minutes of Operation Twist announcement the Dow Jones Index plunged by 280 points and a further 380 points the following day- even before the Fed started the operation itself! Given this was a widely expected move by the Fed, it was hardly surprisinng yet its disruption the markets was massive - the effects was widespread the Korean stock market, for example, fell by 6%...I think the move is comparable to those after the 911 event. Analysts at a loss to explain this had to come up with something - some say the selling was due to worsening economy, others say it is due to the problems in Europe etc. However, why did all the selling occur just after the US Fed announcement? Why did gold which as been a safe haven also fall if markets are worried about Europe and global economy?
If you go back to the seconds after Operation Twist was announced, you will notice that short term interest rates moved up. No surprise since Twist was suppose to move up short term rates and move down long term rates and bond markets anticipate the effects of the 'twist' reacted accordingly. Next sequence in the chain of events is the US$ spiking up due to the movement of short term rates. Short term rates is one of the factors that affect the exchange rate between countries i.e. if rates move up, the currency strengthens. Now that takes us to the connection between US$ and risky assets - when US$ falls, risky assets such as commodities and foreign stocks go up. This connection is due in part to the US$ carry trade in whcih speculators borrow cheaply US$ to speculate in all sorts of markets - when the US$ is falling, money will flow into these markets as speculators can profit when the assets they are holding is converted back to the falling US$ ..they will be motivated to borrow more to speculate. However, when the US$ rises, the reverse happens - money pulls out from markets such as Asian stocks, commodities etc and cause sharp falls.
I think most savvy investors know of the individual links between rates and US$ ...and US$ and risky assets. However, it is the ferocity of chain reaction that caught many by surprise - much of which caused by computerised trading algorithms that automatically sell certain assets when parameters of their model change. I went through analysts forecast of what will happen if Operation Twist was announced and the consensus was nothing much since it was expected a few predicted it will be short term positive for stocks. Apparently, the collective behavior of man, machine and feedback loops eluded everyone. The main opponents of Operation Twist didn't like it because they fear it risks inflation and they believe it will prove ineffective - nothing to do with what we have seen since the announcement in fact inflation fear should subside since price of commodity and oil fell . I don't think the US Fed figured it out ahead of the announcement because the chain reaction triggered by Operation Twist was so large and disruptive, it may undermine what Operation Twist set out to achieve.
So after the stock market falls, will we see a rally once chain reaction stops and reverses? The US$ spike up 8% in 3 weeks vs S$, my take is once it starts to weaken against $S, we may see a reversal of 'negatives'....and it may come sooner that anyone expects.
UPDATE : Despite criticism that the earlier QE1 & QE2 did little for the actual economy, thee is another perspective to this. Despite high unemployment, it could be the US economy might be in far worse today if not for QE1 & QE2. A research paper published recently estimated the UK's QE boosted its economy by roughly 2% in 2010[Link]. It is easy for critics to point to the poor shape of the US economy and say various stimulus and Fed action have failed but the Financial Crisis of 2008 could have resulted something far worse if not for the actions of the Fed. The poor US economy is likely to by used in the 2012 US presidential elections by various right wing groups such as the Tea Party to promote ideologically driven solutions. Lets not forget how we got here into this global mess - globalization, banking deregulation, privatization and free market capitalism as the cure for everything.
Printing money is no free lunch. It causes inflation and basically erodes the savings of retired Americans who have their money in fixed deposits. Tharman has so far protected Singaporeans by allowing the S$ to appreciate against the US$ each time the US Fed turns on the printing press. This keeps the price of imported food and fuel steady in S$ There is a limit to how much MAS can do this - our exporters are suffering due to the strength of the S$ and their profit margins are getting squeezed.
The Fed will do another round of QE despite the political opposition he faces - one Republican president threatened to do something unspeakable to Bernanke if he does another round of QE [Link]. While it is politically unpopular due to its inflationary effects, each time they stop doing QE the economy and the stock market seems to start sagging. QE gives 2 kinds of boost - first it keeps the US dollar down and US exports competitive and it hopes to keep interest rates low to encourage consumers to borrow and spend...and businesses to borrow and expand. The unintended effect is a lot of the money is borrowed for speculation causing unwanted flows into developing/asian countries - the speculators borrow US$ cheaply and move it into S$ to buy Singapore property and stocks to make money from capital appreciation and the strengthening S$.
The Fed is expected to announce QE3 this week. It uses a different mechanism from QE1 & QE2 and is expected to have roughly 70% of the effect of QE2. Here is a professor who made a video to explain Operation Twist and potential problems clearly:
It will be interesting to see if the stock market rallies again on QE3. QE3 buys some time for the US economy ....but unless the economy improves dramatically, I suggest you watch out for the end date of this QE because so far the end of earlier QE has coincided with very nasty market selloffs.