The U.S Federal Reserve is an enormously influential player in today’s economy. For many Americans, the Fed is a cryptic entity whose involvement in the economy seems undefined and ambiguous. The reality is that the Federal Reserve is a go-between for the U.S government and the banking system. Member banks of the Fed buy Fed loans which provide asset security as well as improve liquidity. The U.S Federal Reserve has many other functions, including the implementation of economic policy aimed at affecting the economy on a broad scale. The policies instituted by the Fed have both positive and unintended effects on the stock market, but the way the market reacts can often be as influential as the policy itself.
In mid-March the new Federal Reserve Chair Janet Yellen announced that the Fed would be reducing the number of bonds purchased in its quantitative easing program.* As of March, the Fed was buying $55 billion in treasury and mortgage backed security bonds, and announced that it would incrementally decrease bond purchases by $10 billion per month, ending the buying program in October. This policy implemented by the Fed is also known as “quantitative easing”. Quantitative easing happens when the Federal Reserve purchases long-term government debt and mortgage bonds. This in turn lowers the interest rates at which companies and consumers must pay to borrow money. In theory, if companies and consumers pay less for interest on loans, they will be more willing to purchase goods, or invest in the stock market. However, if bond purchasing by the fed continues too long, it can lead to inflation as a result of an increased total money supply resulting from bank lending.
In April, Yellen announced in her press talk that “Interest rates will likely stay at current levels for a considerable time after asset purchase program ends.” This in part helped the Dow jump 162 points, as well as give the S&P 500 and Nasdaq a 1% boost on press day.* Similarly in June, the Fed maintained that interest rates would remain the same at least until the end of 2014. This was based on the “dot plots,” or forecasts created by Federal Reserve officials on key interest rates. Bolstered by this news, the Nasdaq reached a 14 year high, a trend which continued into the next week before evening out.*
This was not the first use of quantitative easing. Quantitative easing has been used in three episodes, the first being implemented in November 2008*, followed by QE2 in November 2010, and finally QE3 in September 2012. Market reaction to quantitative easing seems nebulous at first. The day of QE1, the market saw mixed reviews. In QE2 and QE3 however, the market saw marginal to above average gains. This is likely due to the fact that this was until then an unprecedented move by the Fed. As market reactions in the table below show, the market responded much more positively to QE2, and QE3.*
In September 2011, the Fed released it’s revamped “Operation Twist” plan, which was a tactic used previously in the 1960s. In “Operation Twist” the Fed would sell $400 billion in short term treasuries and instead buy longer term bonds. The purpose of this plan was to lower yields on long term bonds. If long term bond yields are lower, interest rates would follow suit, creating a more palatable market for longer term investments such as mortgages, and business loans while keeping interest rates for shorter term loans unchanged. Operation Twist was also used as a means to combat projected inflation increases due to quantitative easing. While in theory this appears to be a just solution to the problem, it ultimately was not enough to change the fundamental issue for investors.*
While many investors were expecting the implementation of “Operation Twist” it did nothing to assuage their fears as the Dow Jones continued its downward spiral from which it would take weeks to recover.* This is in large part due to the already shaky confidence of investors in the weak market, but also the fact that many thought the Fed had played it’s best hand, and it wouldn’t be enough to alleviate the woes of the U.S market. Many critics argue that Operation Twist was a meager solution to a large scale problem. The fact of the matter is: Operation Twist ultimately failed because it tightened the monetary supply. The Fed attempted to avoid inflation, and in doing so caused much more harm than good. Growth and employment, not inflation, are the defining challenge of monetary policy in a slack economy like ours.
The saliency of the Fed’s announcements continue to appear evident in the stock market. Just this week, Chair Yellen remarked on valuations of social media stocks, saying they were “substantially stretched.” Fears of another “DotCom” bubble suggested by the Fed’s annual report propelled investors to dump social media stocks, including Facebook, Twitter, and LinkedIn which all closed down.*
The European Market is also subject to the policies of its central bank. In August 2012, the European Central Bank announced it would take part in outright monetary transactions (OMTs) within secondary, sovereign bond markets. In essence, the E.U Central Bank would purchase government bonds in failing markets, thus lowering interest rates. Specifically, the Central Bank purchases short term bonds which mature in 1-3 years in order to bring longer term bond yields (10+ yrs) down. This alleviates some of the borrowing costs for countries having problems selling debt, thus restoring, in theory, investor confidence in those markets. This policy was not unanimously popular however, despite its critics, the OMT announcement in September 2012 inspired a sharp increase in the U.K, French, and German Markets.*
This June, the ECB announced a nearly unprecedented change in deposit rates: it would go negative. Until recently, like the U.S, banks around Europe would store money in the Central Bank and receive interest. The ECB announced for the first time banks would actually be charged to store money in the Central Bank, with the interest rate dropping to -0.10. In theory, this would persuade banks to lend to individuals and businesses, instead of stockpiling their cash reserves. The central bank was under close scrutiny to take action after inflation fell from 0.7% in April to 0.5% in May. Mario Draghi, President of the European Central Bank, also noted that these new policies opened the door for quantitative easing, as seen in the U.S. Draghi’s conference which unveiled the central bank’s new policies proved to be a boon for the Germany’s Dax 30 which rose above 10,000 as a result of the press conference.*
Crossing the Pacific to Japan, we see another troubled economy whose central bank has instituted new bold policies to alleviate the country’s financial woes. Japan’s economic struggle has been centered around deflation, which has plagued the country for the last 20 years. In 2012, Prime Minister Abe Shinzo issued his “three arrow” plan intended to bring about an economic renaissance, and end the deflation which has crippled the Japanese economy for so long. The “arrows” include: 1. Quantitative Easing 2. Public investments in infrastructure and 3. Trade liberalization and special economic zones. Quantitative easing began in early 2013 with the hopes of combating deflation by spending $70 billion on government bonds, and doubling the amount of currency in circulation. Spurred by the potentially positive outcome of the news, the Nikkei Index rose by over 2.2%.*
So what does this mean for the Fed, the ECB, and the Bank of Japan? The message is clear—just look at the chart below. Every time a Central Bank has acted aggressively to support growth and combat economic slack, markets have jumped in value substantially. Conversely, when money has been tightened, either intentionally or not, markets have dropped substantially. The market verdict is in: Central Banks need to focus on growth, reducing slack, and fixing the jobs crisis. The only question is how long it will take policy makers to solve this problem. In Japan, it has taken twenty years. People in Europe and the US cannot afford to wait that long. The sooner we fix growth, and therefore fix the jobs, the better.
*The chart below details the date of a given Fed, or central bank announcement with a corresponding market reaction.
This post was contributed by Derrick Miedaner