Recently I came across an article refuting the effects of quantitative easing on stock markets. The author based his conclusions on the argument that the secular decline in mortgage rates since early 1980s is not due to changes in federal funds rates, or quantitative easing. Therefore, federal funds rate, or quantitative easing, is not the cause of high PE tolerance of stock markets. This is a bold conclusion given academics have a consensus on the impact of quantitative easing on stock markets; the only difference of opinion is on the channel of transmission of the quantitative easing operation.
Did federal funds rate affect long-term interest rates?
In short, yes. Some critics argue as federal funds rate is the rate at which banks can borrow money overnight, it only affects short-term lending rates. However, this view is weak given the evidence to the contrary. First, if long-term rates are not to adjust in response to short-term rates, there exists an opportunity for arbitrage as short-term rates can be used to mimic long-term rates by rolling over. In simple terms, rolling over a 1-year interest paying instrument for five years should be equal to an instrument with a maturity of five years. Therefore, increase in short-term interest also increase long-term yields due to removal the arbitrage. Moreover, long-term mortgage rates have been declining since 1980s. Although, of late, Federal Reserve has started to hike rates, short-term federal funds rate was following a declining path in the past, which is in line with the decline of long-term mortgage rates. Overall, there’s little evidence that short-term rates don’t affect long-term rates.
When it’s established that short-term rates do affect long-term rates, it’s not difficult to see the impact of short-term rates on stock markets. For starters, the famous discount model relates earnings to price through discounting. Rising rates should equal lower present value and lower stock price and vice versa. Furthermore, if long-term rates are down, investors of fixed income are tempted to move their funds to high yielding markets like equities in order to maintain their returns. All in all, there is clear evidence that lower rates boost stock market returns. The converse is also true. To that end, the rising rate environment of today should be considered bearish for equities. Investors shouldn’t ignore the rising rates environment as it can move funds away from equities to fixed income securities.
Did quantitative affect long-term rates and stock markets?
Again, yes. Federal Reserve increased its balance-sheet assets through quantitative easing, which resulted in shortage of supply of certain fixed income securities including mortgage based securities and agency debt in the market. This resulted in shortage of supply, leading to higher prices and lower yields for those particular assets. This also potentially increased the prices of other similar securities when investors turned to alternative fixed-income securities. Overall, the reduction in supply pushed the yields of fixed income assets downwards.
What happened then? Investment managers and institutional investors moved their funds to high yielding alternative assets like equities. Moreover, quantitative easing also increased the deposits of institutions involved in selling securities to the Federal Reserve. Those deposits were potentially used by institutions to buy risky assets like equities because yields were too low to invest the money in fixed income assets. The point is that there is evidence of quantitative easing’s impact on, both, the long-term yields of fixed income assets and stock markets.
Final thoughts
Low interest environment along with high liquidity of financial institutions is supporting the current high PE environment in stock markets. However, the Fed has already started its balance sheet normalization and is also hiking rates. 2018 doesn’t seem to be a good year for equity markets, especially for passive investing. The impact of reduction of quantitative easing, and hike in rates, isn’t yet visible because there’s a lag between the reduction of balance sheet assets and the impact on stock markets. You can read about the potential reason for delayed impact of the reversal of quantitative easing here. Anyhow, investors should remain cautious as far as passive investing goes; value investing should be the go to approach for investors during the next couple of years.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
