Quantitative easing (QE) was once an unconventional tool of monetary policy whose mechanics were as inscrutable and esoteric as the term itself. But since the global financial crisis of 2008, the tool has become a standard instrument of central banking, and the term has become a common fixture in analyst research and pundit commentary. According to the Federal Reserve, America’s central bank, the goal of QE is to spur economic activity by lowering long-term interest rates, especially when short-term rates have already been cut to zero. Although the ability of QE to stimulate real economic activity is a matter of debate, one area in which the policy has been indisputably effective is in boosting the stock market. To understand the three channels through which QE can raise share prices, one first needs to understand the basics of how the tool works, both in theory and in practice.
When the economy falls into a recession, the traditional central bank reaction is to cut short-term interest rates in an attempt to increase credit creation and rekindle economic growth. As rates approach zero, however, the bank encounters what academics refer to as a liquidity trap. Because investors will simply hold cash when interest rates are significantly below zero, traditional monetary policy becomes ineffective in easing credit conditions. To further support the economy, tools beyond the textbook are needed. Enterprising central bankers noticed that longer-term yields were still far above zero, and began to design policies to impact the far end of the yield curve, where central banks have traditionally had far less control of interest rates.
Central banks use QE, the resulting policy tool, to lower long-term interest rates by conducting large-scale asset purchases on the open market. In recent years, the Fed has purchased Treasuries, mortgage securities, and even corporate bonds. Because these assets subsequently reside on the Fed’s balance sheet, the tradable market supply is lowered, driving prices up and yields down. These purchases are financed by creating new reserves, a form of money-printing that is not necessarily inflationary, since only commercial banks can hold reserves.
The most direct way QE raises share prices is by lowering the discount rate needed to value future cash flows. While the equations are best left to the analysts, an intuitive way to understand this argument is to recognize that a potential payoff of $120 a year from now is more valuable if the risk-free payoff over the same period is $101 than if the risk-free payoff is $105. Viewing a stock as nothing more than its expected future cash flows works perfectly in theory, and imperfectly in practice. But while discounted cash flow analysis may seem antiquated in the age of meme stock enthusiasm, it still acts as the intellectual foundation for valuation methods used by institutional investors. By lowering long-term interest rates, QE makes potential future dividends more valuable and thus raises share prices, especially for growth companies whose payoffs lie far in the future.
An important implication of lowering the discount rate is that the expected return for holding equities has declined, since stocks have gotten more expensive but expected dividends have remained the same. This phenomenon manifests itself throughout all asset classes, as prices of any cash flow rise given a lower discount rate. Investors who need to target a certain rate of return, such as the managers of a defined-benefit pension plan, may find that their current portfolio will no longer generate the expected returns they need to fund their obligations. In lieu of any other options, these investors will reach for yield, opting to bear more risk in order to meet their return target. Equities will be bought instead of high-yield bonds, which will be bought instead of high-grade corporate bonds, which will be bought instead of government bonds. This process, known as the portfolio rebalancing effect, will drive up prices on riskier securities given the increased demand for them. It is the second transmission channel through which QE drives stock prices higher, and is pithily captured in a turn of phrase commonly associated with why investors purchase US equities – there is no alternative.
The third conduit that translates QE into higher stock prices is the increase in corporate leverage that accompanies a lower interest rate. Companies are limited in how much debt they can issue to finance their operations, since more debt means a higher servicing cost. With a lower interest rate, however, companies can finance themselves with a proportionally higher share of debt per dollar of interest. When increased debt issuance is combined with increased stock buybacks, companies can meaningfully shift the composition of their capital structure to concentrate ownership among fewer equity holders. With fewer outstanding shares of ownership, each share is worth more, driving the stock price higher. While this leverage increases the fragility of companies in a downturn, the expansionary monetary policy that drove down interest costs also directly reduces the likelihood of such a downturn.
Although the Fed’s language focuses on spurring real economic activity, lifting the stock market is a goal implicit in the techniques and objectives of QE. The Fed cannot change the material risk of economic projects, but they can make it cheaper to finance those projects. Since a cheaper cost of new capital also means a higher price for existing capital, the result is higher stock prices than would occur without QE. Moreover, the wealth effect that causes investors to consume more after seeing their portfolios rise in value aligns with the Fed’s goal of stimulating growth. Unconventional tools may come with unintended consequences, but they may also come with some quietly intended consequences.
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