Prophecy Fulfilled?

John Lim

QUANTITATIVE EASING, or QE, has been the Federal Reserve’s policy of choice since interest rates reached their lower bound of 0%. The brainchild of then-Fed Chair Ben Bernanke, QE was launched in the midst of the 2008 financial crisis. Quantitative easing is simply a euphemism for bond purchases—Treasury bonds and mortgage-backed securities—by the Federal Reserve.

In theory, QE should lead to lower interest rates, as reflected in bond yields. Bond prices are, of course, subject to the forces of supply and demand. All else being equal, greater demand—such as from Fed purchases—drives up bond prices. And when bond prices rise, their yields fall.

Lower interest rates have a plethora of effects, both on the economy and financial markets. Low rates stimulate the economy and drive up the price of financial assets, hence the term quantitative easing. QE is widely assumed to result in looser financial conditions.

That’s all well and good, but financial markets are comprised of human beings, not machines. They react in ways that incorporate expectations of the future. I would contend that QE is as much a behavioral construct as it is a financial one. What does that mean for the stock market? We’ll find out in the months ahead, now that the Fed is winding down its bond purchases.

The Federal Reserve acknowledges that forward guidance plays a key role in its interest rate policy. That term, forward guidance, merely refers to the collective expectation of market participants about future interest rates. The Fed guides market expectations by carefully choosing the words it uses in press releases and speeches. If the market becomes convinced that lower interest rates are on the horizon, that expectation by itself can move markets far in advance of the actual interest rate cuts.

QE has a similar impact on investor psychology and behavior. Since the 2008 financial crisis, we’re now on something like the fifth round of QE. Along the way, we’ve experienced a largely uninterrupted bull market that has taken the S&P 500 from 666 to 4726. The one bear market since 2008 was precipitated by the COVID-19 pandemic. The market bottomed in March 2020, when the Fed announced its latest iteration of—you guessed it—QE.

Is the high correlation between QE and the rising stock market a coincidence? Correlation, after all, does not equal causation. While we may never know for sure, I believe QE is widely perceived as a tailwind for the stock market and has become embedded in the psyche of investors.

Here’s how this feedback loop works: Something bad happens to the economy or markets –> Investors panic and sell financial assets –> The Fed institutes or ramps up QE –> Investors expect QE will lead to looser financial conditions and buy financial assets –> QE has become a self-fulfilling prophecy.

This formula has worked splendidly for the past 13 years. U.S. stocks are up sevenfold over that period, not including dividends. This has enabled thousands to retire sooner than expected. What’s not to like about QE and investors’ Pavlovian reaction to it? Lots.

First, to be effective, each round of QE must be larger than the prior one. If QE has become a behavioral phenomenon, the psychological impact of a modest round of QE just won’t cut it. Like a drug addict, each dose of QE must be ever greater to provide the same investor high. Moreover, by printing ever-more dollars, the Federal Reserve may win the battle, only to lose the war—by debasing the dollar.

Second, before the Fed can raise interest rates, it must reduce, or taper, QE. That, at least, is the sequence of events the Fed seems to favor. This means that interest rates, specifically the federal funds rate, must be held lower for longer. Instead of simply raising interest rates, the Fed must first taper QE and then raise rates. In short, the Fed has built a longer runway between an overheating economy and tighter monetary policy. This greater lag may lead to more extreme economic cycles.

Third, and most important, the Fed now finds itself between a rock and a hard place, thanks to inflation. When inflation was tame, the Fed was free to pursue QE and a zero-interest-rate policy. Now that the Fed has all but admitted that inflation is no longer transitory, it’s a new ballgame.

The Fed must now pick its poison. QE and low rates may stimulate the economy, but will likely exacerbate inflation. On the other hand, withdrawing QE may tame inflation, but at the risk of triggering a stock market selloff. After all, if investors have come to associate quantitative easing with higher stock prices, won’t they view the absence of QE—or worse yet, quantitative tightening when the Fed sells its bonds—as the death knell for stocks? We’re now learning the answer.

Faced with stubbornly high inflation, plus the recognition that interest rates cannot be raised until QE has formally ended, the Fed announced this month that it would accelerate the taper of QE. Stock investors initially responded with enthusiasm, only for share prices to turn choppy. If QE has become a behavioral salve, investors may need to gird themselves for greater stock market turbulence.

John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.

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