Major central banks around the world have thrown the kitchen sink at markets during coronavirus related selling. Never before have we seen such extraordinary measures, with policy makers signalling that they will do what ever it takes to stop bond and equity prices from selling down.
Seemingly the most important of monetary policy tools at the moment are the massive bond buying programs that the central bankers are currently engaged in. This is a process known as quantitative easing and it is an attempt to influence interest rates beyond the overnight market interest rates that are traditionally the realm of central banks.
By buying up longer-maturity government bonds, or even corporate bonds, the central bank is pushing the price of those bonds higher, lowering their interest rates (as yields are inversely correlated to price). This process helps make borrowing cheaper and could reduce credit risk as a result, but importantly, it also releases money to bond holders for further endeavours.
That is why financial asset markets have historically rallied extremely strongly on the back of central bank bond buying. Looking back to “QE2” and “QE3”, which were the second and third post-GFC quantitative easing programs from the US Federal Reserve, running from late 2010 to late 2015, we can see a correlation between the Fed’s bond purchases and movements in the US S&P 500 share index.
While there has only been around one-month of data for this fourth quantitative easing program from the Fed, the movements of the S&P 500 so far look similarly correlated this time around.
This effect is likely multi-faceted, with the Federal Reserve lowering borrowing costs and perceived credit risk, the outlook for shares becomes more attractive. At the same time, bond prices get pushed to more expensive levels and privately held funds that were previously locked in bonds become liquified for further use. With bonds now relatively more expensive, some of these funds flow into shares.
This time around, the Federal Reserve is not just buying government bonds, but also corporate bonds, and shortly, bond ETFs. This is helping to sure-up prices of corporate debt and will make it easier for companies to borrow money. Domestically our Reserve Bank of Australia (RBA) is engaging in their first ever bond buying program – although it has been relatively small so far (around $AU50 billion), and the bank may already have completed its program.
There are concerns about the other costs of quantitative easing, with some economists suggesting that the process will lead to inflation, although we are yet to see much evidence of this as of yet.
There are stronger arguments however, that the process leads to increased wealth inequality with a Bank of England report from 2012 showing that its quantitative easing policies had benefited mainly the wealthy, with 40% of quantitative easing gains flowing to the richest 5% of British households. Indeed, Former Federal Reserve Bank of Dallas President Richard Fisher has said that the cheap money brought about by quantitative easing has made rich people richer but has not done quite as much for working Americans.
On top of this, some developing nations have complained that the programs have amounted to protectionism and that developing nations have been put at a disadvantage. These complaints centre around the currency devaluation that arises from the low interest rates cause by QE.
Regardless of how you feel about it, quantitative easing is a monetary policy tool that is likely here to stay, to be wheeled out whenever there is a severe enough crisis. As traders and investors, we need to acknowledge this and consider the effects that the policy can have on equity prices.
Sam Green is the Portfolio Manager at Emerald Financial, whilst also being an Equities and Derivatives expert for his clients at TradersCircle.
Latest posts by Sam Green (see all)
- XJO to rise despite slight US pullback - August 30, 2024
- Markets jump strongly higher - July 29, 2024
- US shares drop with tech selling, XJO to continue lower - July 25, 2024
1 Comment
trader1337
Good article
Reply