Unless you’ve been living under a rock, you may have noticed a jolt of optimism about the economy suddenly filling up airtime. A 22% rise in August 2010 construction starts and the prospect of further quantitative easing(*) shot the markets upwards over the past two weeks. Many commentators insist that the U.S. has turned the corner and is now charging ahead to recovery. The construction starts have their merit, yet should be interpreted with caution. The numbers are highly seasonal. An average quality construction project takes 3 months from start-to-finish making August the last month to start a project for anyone hoping to complete it before the winter freeze sets in. Due to this seasonality, construction starts can only be expected to decline until at least March 2011.

Quantitative easing is a separate animal altogether, and should also be considered in depth prior to jumping to conclusions, particularly given the looming U.S. elections. According to the research of Alex Dreher and Roland Vaubel (Journal of International Money and Finance, 2009), prior to the elections, many administrations engage in stealth quantitative easing by masking their actions in foreign exchange transactions. Market participants, in turn, unable to trace the sudden spurt in economic growth propped up by temporary drops in interest rates, attribute the observed phenomena to real economic expansions. The temporary euphoria that follows is particularly convenient to the incumbent governments during the pre-election periods, such as the one we find ourselves in right now. The research of Dreher and Vaubel shows that such convenient engines of the feel-good stimulus are common in many of the 146 countries surveyed, and are a possible cause of the economic optimism observed in the U.S. right now. If so, the optimism and the markets are bound to nose-dive right after the elections are over.

(*) What is “quantitative easing,” by the way? Arguably invented by Ben Bernanke himself (see Bernanke and Reinhart, 2004, in the American Economic Review), “quantitative easing” refers to the process of expanding the Fed’s balance sheet, and specifically to increasing the amount of money the Fed has at its disposal to buy and sell Treasury securities. By intervening with the normal market supply and demand of Treasury securities, the Fed is able to influence the prices of these securities, and ultimately to change the yields or interest rates. By expanding the Fed balance sheet to buy quantities of 4-week U.S. T-bills in the open markets, for example, the Fed reduces the supply of the 4-week T-bills available to other investors, driving up prices. Since the price and the yield of bonds are inversely related, once the price of the T-bills rises, their yield falls. The banks respond to the new lower yields by lowering the rates at which they lend to each other, reducing the overall lending rates in the economy, and ultimately stimulating the economy.

Irene Aldridge is a quantitative portfolio manager, former university Finance instructor, and a co-author of “The Quant Investor’s Almanac 2011: A Roadmap to Investing”

This entry was posted on Friday, October 15th, 2010 at 3:49 pm and is filed under Quant Speak. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.