Financial outlook for 2011.

• Author: Boquist, John A.

The financial markets and the economy seem to be in parallel universes. The markets have rebounded strongly since the first quarter of 2009 while the economic recovery has been tepid. We expect that the financial markets and the economy will move closer together, with the markets increasing at a rate somewhat below average.

Despite the dramatic plunge during March 2009, the S&P 500 ended the year with an impressive 23 percent gain, as investors breathed a sigh of relief. The gains have continued in 2010, with the S&P 500 increasing an additional 10 percent from January to early November (see Figure 1). The Federal Reserve has maintained an aggressive position in monetary policy during this period. Short-term interest rates have remained close to zero through 2010 while long-term bond rates are very close to historical lows.

[FIGURE 1 OMITTED]

On November 3, 2010, the Federal Reserve Board announced a new round of "quantitative easing." This term describes the process where the Fed buys assets from banks and other financial institutions. The Federal Reserve has initiated two periods of quantitative easing, frequently called QE1 and QE2. QE1 involved the purchase of about $1.7 trillion of mostly mortgage-related assets from banks and ended in April 2010. The motivation was to reduce the risk exposure of banks by removing their distressed assets and simultaneously providing banks the liquidity to make new loans. QE1 has been successful in improving the financial condition of banks, although overall loan growth remains weak. QE2 has targeted the mid- to long-term portion of the Treasury yield curve. The idea is that when the Fed purchases these bonds, their price will rise and their yields will fall. If the yields fall enough, then banks will find it more attractive to make new loans rather than invest in Treasury bonds.

There is a general consensus that QE1 served its purpose, but there is considerable debate about QE2. The two concerns most frequently mentioned are the inflationary potential and the decline of the dollar. So far, the inflationary impact appears to be small. Both Treasury bond prices and TIPS (Treasury Inflation-Protected Securities) show little evidence of future inflation. The commodity and currency markets, however, offer a different perspective. The U.S. dollar has fallen sharply since the Fed indicated its intent to implement QE2. Since this favors U.S. exports over imports, many of our trading partners have been vocal in...