By Alwyn van der Merwe, 13 August 2013
Equity prices came under severe pressure when the Chairman of the Federal Reserve Bank, Ben Bernanke, suggested in June a ‘tapering’ of some of its quantitative easing (QE) policies contingent upon continued positive economic data. Equities sold off and bond yields kicked higher – though from arguably low levels. Since QE is quite technical in nature and we are convinced that this will not be the last time that markets will respond to comments relating to QE, we need to explore the topic further. Expansionary monetary policy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates. However, when short-term interest rates are either close or near to zero, central banks need to go a step further. They may use an unconventional policy measure by buying financial assets or bonds from commercial banks or other private institutions, and often longer duration paper. When they pay for these financial assets, the monetary base of the economy increases (they create money); and the price of the financial assets increases as their yields decline.
Clearly the action stimulates economic activity as the monetary base increases in an environment of low interest rates. As long as the central bank buys the paper, yields will remain low. It also then implies that these prices will remain at artificially high levels.
Equities also benefit from this process. Firstly, following the low yields of interest-bearing assets, investors were looking for non-traditional high-yielding assets to enhance yields in their portfolios. Hence high-yielding equities became popular. Secondly, although equities did not look cheap in historical terms, they certainly looked cheap against artificially expensive bonds. And finally, companies also had the benefit of cheap funding in a low interest rate environment.
Since the financial crisis in 2008 the Federal Reserve Bank has implemented three quantitative easing programmes. The last announcement was on 12 December 2012 when the Federal Open Market Committee (FOMC) announced an increase in the amount of open-ended purchases from $40 billion to $85 billion per month. The strong performance of US equities year to date is now history.
As analysts realised that QE was an important catalyst for the strong equity performance, the last thing they needed was an announcement of a perceived premature withdrawal of the proverbial punchbowl. Therefore the sharp reaction was to be expected.
We commented in June that Bernanke is unlikely to make the mistake of cutting stimulus too early. We thought the markets’ reaction presented a buying opportunity.
With bigger government involvement, however, the risk of a policy error cannot be ruled out and is certainly a variable to ponder.