Posted at 6:00 am
Hi. As far as I know, low interest rates and central banks’ monetary easing have fueled the rise in stock markets and real estate. Interest rates rise. What about monetary easing? How is monetary tightening impacting the market decline?
Gael Le Corre-Laliberte
“The answer is yes, monetary tightening will have an impact on financial markets,” argues Olivier Rancourt, an economist at the Montreal Economic Institute, who was asked to answer our readers’ question.
Essentially, monetary tightening will have the opposite effect of monetary easing, Mr Rancourt warns.
A little background: During the pandemic, the Federal Reserve and Bank of Canada slashed interest rates and bought phenomenal amounts of government bonds with the goal of flooding financial markets with liquidity and keeping long-term interest rates as low as possible by valuation.
“Never before has a firefighter been criticized for using too much water,” Stephen Poloz, then Governor of the Bank of Canada, said in spring 2020.
Bankers have dubbed the massive government bond purchases quantitative easing, a measure the Fed already used during the 2008-2010 financial recession.
A more direct way of explaining quantitative easing is to say that central banks control the level of long-term interest rates by printing money out of thin air and using it to buy government bonds.
The strategy was a success as the economy did not collapse despite the restrictions imposed during the pandemic.
However, the coin has its downside. Central bank balance sheets have grown dramatically with all the bonds they have had to buy. Some also argue that the money-printing strategy has fueled a resurgence in inflation not seen in at least 30 years.
There were other effects, notes Incrementum AG in a recent report entitled stagflation 2.0. Market multiples have skyrocketed with all this cash inflow chasing a limited number of investment opportunities. Investors took risks. Bond yields fell across all categories, including corporate bonds and junk. In Canada, house prices have skyrocketed.
The wind has turned
Today the tide has turned. Inflation has become enemy number one. Central banks have resumed raising interest rates. They have also started, or will soon do so, to resell bonds in the market or, quite simply, to repay them at maturity without buying new ones. In doing so, they take money out of the economy, hence the term “quantitative tightening”.
Commercial banks will respond, explains Mr Rancourt, by looking elsewhere for liquidity as interest rates on deposits rise.
“If the Bank of Canada buys fewer bonds, there will be some upward pressure on long-term 5-10 year bond yields,” adds Jean-François Rouillard, a professor in the University of Sherbrooke’s Department of Economics. When interest rates rise, it usually signals a possible impending economic downturn. »
As the cost of money increases, the cost of financing companies is bound to increase, which will put pressure on their profit margins, the researcher adds. The real estate market will also be affected. “Stock and real estate markets move hand-in-hand through cycles without being a perfect positive correlation,” he says.
Therefore, to echo Mr. Rancourt’s idea that quantitative tightening has the opposite effect as qualitative easing, from now on we have to expect a fall in stock price-earnings multiples, a rise in bond yields and greater risk aversion on the part of investors .
We’ve seen this since the spring with the spectacular decline of bitcoin, a risky asset, and the attractiveness of the US dollar, considered a safer bet. The greenback rose sharply against a basket of currencies.
“People with low risk aversion will now prefer to invest their money in time deposits or fixed-income securities, for example [donnant un rendement de 2, 3 ou 4 %], said Mr. Rancourt. As a result, there will be a fall in prices in the financial markets like stocks. »
The economist argues that this alternative solution did not exist before monetary policy was tightened. Almost everyone had to resort to the stock market to earn a return, which contributed to the high cost.