There is an ongoing debate on the impact of monetary policy on financial asset and macroeconomic volatility, with a number of economists claiming that quantitative easing has induced lower volatility in financial markets, while others believe that low interest rate policy and quantitative easing has created asset price distortions that could eventually create higher volatility both in financial markets, as well as in the real economy.
U.S. quantitative easing was largely based on the so-called “portfolio substitution” strategy, i.e. the purchasing of large amounts of long duration bonds by the Federal Reserve to drive down long-term interest rates, in order to encourage investors to shift from bonds into stocks, increase share prices, raise household wealth, and, eventually, consumer spending. More specifically, the purchase of large quantities of long duration securities brought down risk premia and compressed or removed significant market volatility from equities and bonds, pushing prices and valuations higher.
But is this ‘influence’ on financial markets that stems from major central bank monetary policy confined to the last seven to eight years, or, has it been evolving for a protracted period of time?
The truth is that central banks have been actively ‘cultivating’ the ‘appropriate’ conditions for stable markets for more than forty years. In this short note we show that the FOMC meetings, no matter the direction of the Federal Funds rate decision, has affected equity market returns.
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One of the primary questions that investors should be asking at all times is whether risks are realistically and adequately priced in financial markets. It is true that the pricing of risk is definitely not a straightforward exercise and thus there are numerous instances that investors have been consistently mispricing risks. Typically, periods of prolonged mispricing have been followed by a re-evaluation of expectations and a rise in asset market volatility. Investors have exhibited less risk aversion relative to initial expectations year to date, even though the macroeconomic environment ha...
It seems that equity markets have priced-in a rather optimistic scenario both with respect to the projected macroeconomic and earnings backdrop. In order to get a feeling of the impact of current market expectations on equity market valuation, an econometric framework is employed to proxy and determine the ‘fair value’ of the market.
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