What is quantitative easing, and why does it matter? Will a Fed interest rate hike derail global growth prospects? How will the stock market respond to lower inflation? Will investors panic and induce a global asset selloff? These are the questions that keep Janet Yellen, America's most powerful woman, awake at night.
From a fundamental standpoint, markets are quite simple. For instance, the stock market operates on assumptions, expectations, and results, all of which stem from informational flows. From a securities standpoint, these assumptions appear in the form of earnings and revenue guidance, operational and capital expenses, share repurchasing programs, dividend hikes, and managerial decisions, to name a few. However, overriding macroeconomic expectations, comprised of consumer and producer metrics, unemployment levels, wage fluctuations, inflation rates, and most importantly, interest rates, also govern securities markets. Hence, the performance of NYSE and Nasdaq stocks are largely reliant on a myriad of information. When this information is rational, investors react logically; when this information is unpredictable, investors engage in high volume trading (or selloffs).
Since the 2008 Recession, the Federal Reserve has overseen the largest quantitative easing (QE) program to date, spending roughly $4 trillion to stimulate domestic and global growth. This monetary policy is a tool used by Janet Yellen, the current Fed Chairwoman, to pump cash into America’s financial system. By generating new cash reserves, in exchange for financial securities and debt, the Fed can manipulate inflation and interest rates. In America, QE has lowered interest rates towards the zero bound (a 0% interest rate), at which point money is essentially free to borrow. In principle, when money is cheap, individuals, institutions, companies, and governments are more likely to spend and stimulate global economies. Given that retail transactions comprise 2/3 of America’s GDP, QE is an extremely important policy. However, prolonged QE has created an artificial and volatile stock market.
By introducing cheap capital to markets, securities, more specifically stocks, have on average more than doubled over the past seven years. Yet, recent speculations about looming rate hikes have investors on high alert. Historically, assets appreciate during expansionary periods and “correct” during transitional periods. As such, Wall Street predicts a 10% stock market correction in the months following a 25-basis-point (or .25%) September rate hike. Therefore, with hundreds-of-billions in investor wealth at risk, Janet Yellen and her colleagues appear troubled by the prospect of raising the federal funds rate (the interest rate at which banks borrow and lend from one another). In fact, many prominent analysts, researchers, academics, and hedge fund managers are of the opinion that the Fed has missed all optimal rate hike opportunities and has, thereby, completely jeopardized America’s short-term economic health.
Although I agree with Wall Street’s consensus, I don’t anticipate much of a market correction in response to gradual Fed rate increases. In my opinion, as reflected by stock prices, investors have already accounted for upcoming interest rate changes. While this has generated tremendous volatility in recent months, I believe that most stocks are fairly valued, many having withdrawn from previous highs. This is not to say investors will act rationally upon an official interest rate increase; however, so long as the Federal Reserve adheres to its September plan, I strongly believe that securities markets will remain upbeat. Investor wealth may decrease, but this is a natural part of business cycles. Nevertheless, if you are not as bullish as I, make sure to hedge your bets. In any case, Fed rate fears may now be overblown.