Category Archives: quantitative easing

3/2/21: Monetary Easing and Stock Market Valuation

There has been quite a puzzling development in recent years in the monetary policy universe. A decade plus of ultra low interest rates has been associated with rising, not falling, risk premium in investment markets. In other words, a dramatically lower cost of new and carried debt induced by lower interest rates - a driver for lower risk, is being offset by something else. What?

Laine, Olli-Matti paper "Monetary Policy and Stock Market Valuation" (September 18, 2020, Bank of Finland Research Discussion Paper No. 16/2020: tries to explain. 

To start with, some theory - especially for my students in the Investment and Financial Systems courses. Per author, "the value of a stock is the present value of its expected future dividends... Hence, the changes in stock prices must be explained by 

  • either changes in dividend expectations or 
  • changes in discount rates. 

The discount rate, or (approximately) expected rate of return, can be thought as a sum of a risk-free rate and a risk premium. Theoretically, monetary policy should have an effect on stock prices through the risk-free rates. In addition, monetary policy should affect dividend expectations, for example, through the output or debt interest payments of firms. The effect on the risk premium (not to mention the term structure of risk premia), however, is less clear."

Looking at Eurostoxx50 index components, Laine shows "...that the average expected premium has increased considerably since the global financial crisis. This change is explained by the change in long-horizon expected premia. ... monetary policy easing has had a positive impact on the expected average premium."

Specifically (emphasis added): "a negative shock to the shadow rate is estimated to increase average expected premium persistently. Instead, the results show that monetary policy easing temporarily decreases short-term expected [risk] premia. This means that expansionary monetary policy steepens the slope of the term structure of risk premia."

This is not exactly new, as Bernanke and Kuttner (2005) observed that "expansionary monetary policy generates an immediate rise in equity prices followed by a period of lower-than-normal excess returns. ...However, Bernanke and Kuttner (2005) do not study the effect on the long-run excess returns. My results show that effect on long-horizon expected premia has a different sign. This effect on long-horizon premia seems to more than offset the effect on short-horizon premia."

Interestingly, "Contractionary monetary policy increases the short-term premia temporarily, but decreases long-horizon premia persistently. The effect on average expected premium is negative. Thus, monetary policy tightening actually makes stocks expensive relative to the expected stream of dividends. The results provide no evidence that expansionary monetary policy causes stock market bubbles..."

Here is (annotated by me) a chart showing evolution of implied and actual risk premia:

From theory perspective, therefore, monetary policy "can affect equity prices through the dividend expectations, expected risk-free rates or expected premia":
  • "The effect of expansionary monetary policy on the dividend expectations is probably positive, because expansionary monetary policy can be expected to increase output and firms’ earnings.
  • "Expansionary policy probably lowers the risk-free rates, but it is also possible that the effect is totally different. Central bank’s rate cut can increase risk-free rates, if people think that the rate cut eventually increases inflation. 
  • "As for the expected premium, the sign of the effect is unclear. ... Gust and López-Salido (2014) show theoretically that expansionary monetary policy lowers the premium ... where asset and goods markets are segmented. When it comes to quantitative easing, ... investors who have sold their assets to the central bank rebalance their portfolios into riskier assets, which lowers their expected returns. ... Theoretically, it is also possible to argue that monetary policy easing actually increases the expected premium. If one assumes that there exists mispricing like Galí (2014) and Galí and Gambetti (2015), then the sign of the response is ambiguous. ... This means that monetary policy easing increases the expected premium implied by dividend discount model (see Galí and Gambetti, 2015, p. 250-252)."

So, onto the empirical results by Laine: 

  1. "Interest rates have declined considerably since the global financial crisis, yet the expected average stock market return has remained quite stable at around 9 percent. This implies that expected average stock market premium has increased remarkably. This rise is mainly explained by the premia over a discounting horizon of four years.
  2. "These results may seem unintuitive as the prices of stocks have risen, and ratios like price-to-earnings have been historically high. However, high price-to-earnings ratios do not necessarily mean that stocks are expensive, because the value of a stock is the present value of its expected future dividends.
  3. "When it comes to the role of monetary policy, the results show that monetary policy easing decreases short-horizon required premia, but increases longer-horizon premia
  4. "The effect on expected average premium is positive, i.e. expansionary monetary policy lowers the prices of stocks in relation to the expected dividend stream."

29/9/19: Divided ECB

Divided they stand...


The ECB is more divided than ever on the 'new' direction of QE policies announced earlier this month, as its severely restricted 'political mandate' comes hard against the reality of VUCA environment the euro area is facing, with:

  1.  Reduced forward growth forecasts (net positive uncertainty factor for QE)
  2. Anaemic inflation expectations (net positive risk factor for QE), but reduced expectations as to the effectiveness of the QE measures in their ability to lift these expectations (net negative uncertainty factor)
  3. Low unemployment and long duration of the current recovery period (net negative uncertainty factor for QE)
  4. Relative strength of the euro, as per chart below, going into QE (net positive risk factor for QE)
  5. Related to (5), deteriorating global growth and trade outlooks, with the euro area being a beneficiary of the Trump Trade Wars so far (ambiguous support for QE)
  6. Expectations concerning the Fed, Bank of Japan, Bank of England etc policy directions (a complexity factor in favour of QE), and
  7. Expectations concerning the potential impact of Brexit on euro area economy (another complexity factor supporting QE).
Here is a chart showing exchange rate evolution for the euro area, and key QE programs timings (higher values denote stronger euro):

Meanwhile, for the measures of monetary policy effectiveness (lack thereof) see upcoming analysis of the forward forecasts for euro area growth on this blog in relation to Eurocoin data.

31/7/19: Fed rate cut won’t move the needle on ‘Losing Globally’ Trade Wars impacts

Dear investors, welcome to the Trump Trade Wars, where 'winning bigly' is really about 'losing globally':

As the chart above, via FactSet, indicates, companies in the S&P500 with global trading exposures are carrying the hefty cost of the Trump wars. In 2Q 2019, expected earnings for those S&P500 firms with more than 50% revenues exposure to global (ex-US markets) are expected to fall a massive 13.6 percent. Revenue declines for these companies are forecast at 2.4%.

This is hardly surprising. U.S. companies trading abroad are facing the following headwinds:

  1. Trump tariffs on inputs into production are resulting in slower deflation in imports costs by the U.S. producers than for other economies (as indicated by this evidence:
  2. At the same time, countries' retaliatory measures against the U.S. exporters are hurting U.S. exports (U.S. exports are down 2.7 percent in June).
  3. U.S. dollar is up against major currencies, further reducing exporters' room for price adjustments.
Three sectors are driving S&P500 earnings and revenues divergence for globally-trading companies:
  • Industrials,
  • Information Technology,
  • Materials, and 
  • Energy.
What is harder to price in, yet is probably material to these trends, is the adverse reputational / demand effects of the Trump Administration policies on the ability of American companies to market their goods and services abroad. The Fed rate cut today is a bit of plaster on the gaping wound inflicted onto U.S. internationally exporting companies by the Trump Trade Wars. If the likes of ECB, BoJ and PBOC counter this move with their own easing of monetary conditions, the trend toward continued concentration of the U.S. corporate earnings and revenues in the U.S. domestic markets will persist. 

10/1/19: QE or QT? Look at the markets for signals

With U.S. Fed entering the stage where the markets expectations for a pause in monetary tightening is running against the Fed statements on the matter, and the ambiguity of the Fed's forward guidance runs against the contradictory claims from the individual Fed policymakers, the real signals as to the Fed's actual decisions factors can be found in the historical data.

Here is the history of the monetary easing by the Fed, the ECB, the Bank of England and the BOJ since the start of the Global Financial Crisis in two charts:

Chart 1: looking at the timeline of various QE programs against the Fed's balancesheet and the St. Louis Fed Financial Stress Index:

There is a strong correlation between adverse changes in the financial stress index and the subsequent launches of new QE programs, globally.

Chart 2: looking at the timeline for QE programs and the evolution of S&P 500 index:

Once again, financial markets conditions strongly determine monetary authorities' responses.

Which brings us to the latest episode of increases in the financial stress, since the end of 3Q 2018 and the questions as to whether the Fed is nearing the point of inflection on its Quantitative Tightening  (QT) policy.