A flood of easy money is gushing from the world’s central bank into the global financial markets. The quantitative easing that started in the wake of the 2008 financial crisis has expanded aggressively and now includes significant programs by the United States Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan. In addition, several other countries have engaged in more traditional monetary easing. In May alone, central banks have lowered key rates in Australia, Poland, Hungary, Korea and Israel. It has been a long time since so many central banks moved in the same direction at the same time. This global easing may prove to be the most significant development in economic policy—at least as far as investors are concerned—since Paul Volker killed inflation in 1979. But before we get into all that, we need to lay a little groundwork.
Some basics on Quantitative Easing
Under normal conditions, central banks focus on adjusting the money supply through transactions known as repurchase agreements or “repos”. In a repo transaction, the Federal Reserve buys government securities, usually Treasury Bills, from a bank with an agreement that the bank will “repurchase” the Treasury Bills from the Fed at a specified point in the future. The Fed pays for the TBills by making an electronic deposit in the bank’s reserve account at the Fed. As the bank lends against these increased reserves it injects “money” into the financial system.
The Fed can remove money from the monetary base by doing the opposite transaction, i.e., selling TBills in exchange for extinguishing reserves in a bank’s reserve account.
Quantitative easing functions similarly to a repo, but with three key differences. Under quantitative easing:
- The central bank buys other assets, not just Treasury Bills, directly intervening in the credit markets at many different maturity dates. For example, in the U.S., the Fed is currently buying Treasury bonds and mortgage-backed securities.
- When the central bank buys the security, there is no agreement that the bank will repurchase the asset. In other words, QE purchases result in a permanent expansion of the central bank’s balance sheet. Any reduction in the balance sheet must come from offsetting permanent transactions in the future.
- The size of asset purchases under quantitative easing can be enormous.
The following charts will illustrate what I mean.
Since the Fed launched its quantitative easing program in November 2008, the total dollar value of securities held on its balance sheet has more than tripled. These assets are matched by a corresponding increase in bank reserves—a key component of the monetary base.
Quantitative easing has dramatically changed the maturity of assets in the Fed’s Open Market Account. Even before QE, the Fed had dramatically reduced its holdings of securities with very short maturities. Since QE, the explosive growth in the Fed’s balance sheet has focused mostly in holdings with maturities between 5 and 10 years.
The types of assets held by the Fed have also changed. Under QE, TBills have not been part of the Fed’s open market game plan. Instead, the Fed has been buying mostly Treasury notes and bonds along with some agency mortgage-backed securities.
The result of QE has been a massive increase in the monetary base, primarily in the form of so-called excess reserves. Banks are required to hold a certain amount of money on deposit at the Fed depending on the riskiness of the banks’ assets. Any deposits beyond the minimum are considered excess reserves.
Excess reserves represent the banking system’s untapped lending capacity. In the United States, excess reserves now total more than $1.7 trillion. If even a small portion of these excess reserves were to find their way into the equity markets, the equity market would have room to run. And when we multiply the expansion of liquidity in the U.S. by the similar QE programs in Japan, England and Europe, we can see a veritable tsunami of liquidity heading toward the global equity markets. The upside in global stocks looks very attractive.
What this means for investors
This is great news for investors and probably explains a large part of what has been driving the equity market for the past several months. We think the market likely has several more months before it becomes over extended and we think increasing global liquidity will fuel the rally.
This chart by JP Morgan shows the current value of each developed economy’s stock market relative to its long-term average and to the global market as a whole. The blue diamond shows the current level of a particular country’s valuation index. The brown horizontal line shows the average for the county. The gray bar shows the range for each country’s valuation index.
At present, the valuation index for each developed country is at, or slight below, its average level for the past 10 years and well-below its peak valuation. An inflow of easy money into the market could easily push P/E ratios to their 15 year averages. In the United States, this would translate into a gain of 17 percent from the end of the first quarter 2013. Broader markets, including the real estate and mortgage markets, could see similar effects. We may finally be close to the thaw in the real estate market we have been hoping to see.