re: Discussion of Fed Liquidity’s Impact on Equity Markets

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Sure, so when the original post was made, there was a lot of commentary out there that the “Fed’s QE was making its way into the market.” The original purpose of the thread was to (a) determine whether or not that could actually be proven to be true and (b) if so, how one could “follow the money,” so to speak. Over the course of the thread we’ve learned a lot about what QE is and what it’s not. At a basic level, we determined that it’s little more than an asset swap. The Fed creates digital reserves and uses those to buy Treasuries from banks, in the process reducing the average duration of the liability side of its balance sheet (i.e. all of those newly issued reserves are essentially over night cash liabilities to the Fed). Moreover, the Fed’s purchases of Treasuries creates additional demand for Treasuries and in a manner that is very price agnostic. As such, that can tend to put upward pressure on Treasury prices and downward pressure on Treasury rates relative to where those rates would be required to be if private market participants were the only ones doing all the purchasing. In understanding that, I think I can say the board has collectively realized that the Fed’s QE isn’t necessarily “finding its way into the markets,” but rather has a more indirect impact on markets in that the additional demand for Treasuries puts downward pressure on Treasury rates which in turn puts downward pressure on equity yields (upward pressure on equity prices), assuming equity yields maintain a constant spread against Treasury yields. The other factor that has become apparent is that the Fed’s dovish messaging, giving market participants the impression that “the Fed has their backs,” causes risk to be priced with a much lower premium that what you’d expect relative to historical volatility and current valuation. So, QE is putting downward pressure on bond yields (and by extension, equity yields) and its “whatever it takes” mentality is causing market participants to exert further downward pressure on equity yields in the form of a shrinking equity risk premium relative to history (which, in a perfect world, would be the opposite of what you’d expect to see in an environment of very high valuations; high valuations should mean lower expected returns which in turn should mean lower tolerance for risk). We’ve also talked a lot about whether or not QE is inherently inflationary. The conclusion I’ve come to is that it’s not inherently inflationary, and could even be deflationary in that artificially low rates cause capital to be allocated towards projects that are increasingly unattractive, with said inefficient use of capital having a drag on productivity, and with said drag on productivity having a stagnating or deflationary effect on the economy at large. Nonetheless, given that QE creates bank reserves, and bank reserves can be leveraged by banks to increase loans, QE can be inflationary if instead of sitting idle on bank balance sheets those reserves result in a greater quantity of money in the real economy. We’ve noticed many banks are still being somewhat conservative with their lending given low net interest margins and fewer opportunities for attractive risk-adjusted loans. So, QE can be thought of as planting the seeds for potential inflation, but whether those seeds grow into inflation-bearing trees is in large part dependent upon what banks do with them (hoard them or loan against them). That said, there has been one aspect with this current QE that has been different than previous versions, and that’s that recent QE has been implemented with a view towards not just buying Treasuries from private markets but enabling government deficit spending, and much of that spending (stimulus payments, etc.) has been in the form of helicopter money directly to lower and middle income people who are more likely to spend it. That has been a form of inflationary pressure (M2 expansion) that wasn’t as prevalent in previous QEs. What to make of all of this? The Fed’s actions can have indirect and quasi-direct impacts on markets primarily through the mechanisms of relative asset class yields and investor perceptions towards risk. To date, we haven’t seen the direct impact some other countries have, wherein central banks actually start buying equities themselves. The Fed’s actions can also have indirect, quasi-direct or even direct (if you’re a monetarist) impacts on inflation, particularly if it enables fiscal spending into segments of society most likely to spend those dollars back into the economy. But it can also be long-term deflationary if it causes things like capital to be misallocated, zombie companies to “remain on the shelf” beyond their expiration date, and governments, businesses and households to take on too much debt which eventually requires belt-tightening in order to repay. There you have it. I know it’s a lot, but the thread has covered a lot. There are surely others like wutang and Cork who may have more to add or who may disagree with or see things differently than what I’ve described above.

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