Well, firstly its great to announce that exams are finally over and the summer has begun!
In the news recently there has been a lot of talk regarding the ‘tapering’ (slow removal) of the QE programs. Ben Bernanke has expressed that such tapering would not occur until unemployment falls further down, but with the number of Americans being employed in May reaching 175,000 (above expectations) it can be argued that the Federal reserve might start to question the longevity of their QE program.
But what has QE got to do with Bond Yields and the StockMarket?
After the financial crisis central banks began a program known as QE. Its intention was to buy assets, notably Government Bonds. As the demand for these bonds increased, their yields began to drop, due to demand far outstripping supply; so the issuers of the bonds were no longer having to raise the yields to attract investors.
Low bond yields are great for the stockmarket. Investors begin to earn far less of a return on their investment in the bonds and are therefore forced to look at more risky assets (notably equities) to achieve a higher rate of return, or risk making poor returns. Furthermore firms can begin to borrow at a lower rate, allowing the ability to expand their businesses at a cheaper rate.
The reason why tapering QE might be adverse for the Stock Markets lies within one main factor:
Bond Yields rise
The issue here is that bond yields could rise substantially, and rapidly. This brings back the story of 1994 – where bond yields began rising unexpectedly and their prices suffered a large fall. The result of this was very large losses for the firms with money invested in bonds, which was not kind to their share price.
Investors are worrying a similar situation could occur when QE is reduced, as the demand for bonds will drop (in the USA that is $85 billion less per month) and thus yields will rise and prices will fall. The rise in yields would increase the costs incurred by businesses, and the fall in prices would take many investors (institutional and individual) into the red.
Stockmarket return falls
Associated with rising yields is the issue that the stockmarket will begin to look less lucrative to the investor, if bonds are now yielding higher rates. This would cause a sell-off from investors to lock-in the earnings from the QE program, as they expect the market to fall.
However this all depends on the nature of the Bond Yield rise, if QE is tapered off with a background of strong economic recovery, it is hoped that the benefits from the recovery will outweigh the negatives of less bond purchases. Furthermore investor’s expectations are a vital aspect of how the stock market will react. If investors are expecting that bond yields will rise they will not reacts as grandly (or emotionally) as if it were unexpected.
It is therefore the role of the Fed Reserve, BoE and other Central banks to ensure that QE is tapered under a strong economic backdrop and that there is decent warning and preperation for investors; Ben Bernanke has begun this process by suggesting it might be time for QE to be withdrawn, but its important he does not rush the process.