- Despite all the discussion surrounding quantitative easing (QE), there has been little theoretical justification for the link between QE and equity prices.
- Europe provides a glaring counter-example of the impact of central bank policy on financial markets.
- Once the psychic umbilical cord of QE is cut (tapered), the market may actually be cheered by the end of what has always been perceived as a temporary and extreme form of life support.
Few issues currently cause as much investor angst as the timing of the Fed’s eventual reduction in the pace of quantitative easing, aka tapering. In May, when the Fed first spoke concretely about slowing the rate at which they are buying government and mortgage securities, interest rates around the world rose and stock markets fell, with the biggest pain being felt in those emerging markets most reliant on foreign capital flows as money quickly fled those markets (stocks, bonds and currencies were all dramatically impacted). When, in seeming response to this market riot, the Fed ultimately didn’t taper, stock markets rallied and interest rates declined. This behavioral pattern would seem to bode ill for equity and bond markets when the Fed finally does taper, which by some speculation will occur as early as this month. However, is it possible that this time could be different, that the Fed decision to slow the pace of monetary stimulus might be seen as a positive, or at least not the end of the world as we know it? There are a few reasons to believe that may be the case.
First, despite all the discussion surrounding QE, there has been little theoretical justification for the link between QE and equity prices. Clearly there is the empirical observation that the path of stock markets in the U.S. has tracked the size of the Fed’s balance sheet almost 1:1. But why is that the case? If the additional money being pumped into the economy through Fed purchases of securities from banks is simply re-deposited with the Fed in the form of excess (unused) reserves, the institutional equivalent of burying the money in your backyard, what real economic impact is there? If the money simply sits, real activity is unaffected, so the link to changes in equity values is tenuous at best. Then there is the wealth effect argument, that rising asset values (as opposed to rising incomes) increase the propensity to consume, creating a self-reinforcing cycle, but both the theoretical and empirical evidence to support this is weak as well.
Second, there is a glaring counter-example of the impact of central bank policy on financial markets, which is Europe. As you can see in the chart below, despite a fairly steep contraction of the ECB’s balance sheet, equity markets have powered ahead. Bond yields, even in the troubled peripheral markets, have continued to decline. It’s hard to reconcile the notion of a positive causal link between central bank balance sheet size (or change in size) and equity prices given the starkly divergent pattern in Europe.
Source: BCA Research
One thing to remember though is that if enough people believe something to be true, then in terms of market action it is true, as the weight of their collective decisions are going to drive prices – at least in the short term. So if the collective wisdom decides it is the ongoing change in the size of the Fed’s balance sheet that is relevant for markets, and the decision to taper is made, look out. We’ve been through this process once already though, and markets have had time to prepare for the ultimate tapering decision, which universally seems to be acknowledged is a matter of when, not if. So is it really as simple as hitting the rewind button and replaying May’s response once the decision to taper is ultimately made? Further, despite the tapering discussion, the Fed has made it clear that it is unequivocally dedicated to nurturing the fledgling economic recovery we’ve been experiencing, and rising asset markets are one of their key indicators, so at the first sign of an actual deceleration, they will press back down on the monetary accelerator. In fact, Janet Yellen, the imminent successor to current Fed president Ben Bernanke, is collectively viewed as even more dovish than he. The Fed’s got our (the market’s) back. They’ve made it clear that severe/sustained economic or market declines will not be tolerated. The Greenspan/Bernanke/Yellen put is alive and well, and the market believes it, so the risk of an extended adverse reaction to the eventual taper is pretty low.
The good news is that it’s possible we will know as early as Wednesday what the market reaction is going to be, as that is when the Fed announces its monetary policy decision for December. If the tapering decision is not made this month, then we will have to wait for the next meeting in January. If not then, we’re on the hook until spring. One thing we do know: the market dislikes uncertainty, and once the dreaded tapering finally does occur and the psychic umbilical cord of QE is cut (tapered), the market may actually be cheered by the end of what has always been perceived as a temporary and extreme form of life support.