Week In Focus -Rational Response

Week In Focus -Rational Response

July 2nd, 2013

Equity markets may have recovered some of their equilibrium over the past week or so but the extent to which they were swayed by the prospect of quantitative easing (QE) being tapered has worried some observers. Are investors so hooked on monetary stimulus the merest hint of its withdrawal will send markets sliding, in apparent defiance of the prevailing economic climate?

There has been a lot of talk about equity markets’ ‘addiction’ to QE. They love the liquidity it provides and the money sloshing round the system. With each bout of QE, they have risen and when US central bank chairman Ben Bernanke suggested – surely to the surprise of no-one – that at some point the Federal Reserve would have to taper its monthly purchases, equity markets sold off. This seems to fly in the face of standard equity market behaviour. Equity markets should respond positively when the global economic climate is improving – yet the withdrawal of QE has to be a sign of precisely that and still they sell off. This, at least superficially, is worryingly irrational behaviour for potential investors. However, it could be argued there is some rationality behind the equity market’s reaction to the situation in bond markets. QE has created a benign environment in which governments and companies enjoyed exceptionally low borrowing costs, giving them the best possible chance of creating growth. The reversal of that trend creates a more difficult environment for growth. Equally, it may not be what Bernanke had intended but the bond markets’ reaction to his comments has created de facto monetary tightening. Government bond yields have risen, which have in turn pushed up mortgage rates. This threatens to stall the nascent US housing recovery while, in areas such as the UK, the impact may be even worse. In this sense, the equity market’s response to the potential end of QE has been entirely rational. The monetary tightening created by this weakness in the bond markets will surely create a more difficult growth environment. Investors should perhaps take some cheer from the fact that talk of markets’ ‘addiction’ to QE – with all the irrationality that implies – may be wide of the mark. They may also take comfort that there are signs of a connection with economic growth re-emerging. Bernanke has had to intervene to calm bond markets but equity markets have stabilised as economic data from the US has come through relatively strongly. Perhaps equity markets are starting to break their dependency on quantitative easing after all.  

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