Posted at 6:00 a.m.
Hello. From what I understand, low interest rates and monetary easing by central banks have fueled the rise in stock markets and real estate. Interest rates are going up. What about monetary easing? What is the effect of monetary tightening on the market decline?
Gael Le Corre-Laliberte
“The answer is yes, monetary tightening will have effects on the financial markets,” argues Olivier Rancourt, economist at the Montreal Economic Institute who was asked to answer our reader’s question.
Essentially, monetary tightening will cause the opposite effects of those created by monetary easing, warns Mr. Rancourt.
A little background: during the pandemic, the Federal Reserve and the Bank of Canada cut their key rates to the bottom and they bought phenomenal quantities of government bonds with the aim of flooding the financial markets with liquidity and maintaining the lowest possible long-term interest rate.
“A firefighter has never been criticized for using too much water”, was justified in the spring of 2020 Stephen Poloz, then Governor of the Bank of Canada.
Bankers have given the name of quantitative easing to the massive purchases of government bonds, a measure that the Fed had already used during the financial recession of 2008-2010.
A more direct way to explain 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 debt. .
The strategy was a success since the economy did not collapse during the pandemic, despite the confinement.
However, the medal has its reverse side. Central banks’ 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 the likes of which has not been seen for at least 30 years.
There have been other effects, Incrementum AG notes in a recent report titled Stagflation 2.0. Market multiples have soared with all this influx of money chasing a limited number of investment opportunities. Investors have taken to risk. Bond yields of all categories fell, 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 their key rates. They have also started, or will do so shortly, to resell bonds on the market or quite simply to be reimbursed at maturity without buying new ones. In doing so, they will take money out of the economy, hence the term “quantitative tightening”.
Commercial banks will react, explains Mr. Rancourt, by seeking liquidity elsewhere, with the increase in interest rates on deposits.
“If the Bank of Canada buys fewer bonds, there is some upward pressure on long-term bond interest rates of 5 to 10 years,” adds Jean-François Rouillard, professor in the Department of economics from the University of Sherbrooke. Usually, when interest rates rise, it signals a possible upcoming economic downturn. »
With the rising cost of money, the cost of financing companies will necessarily increase, which will put pressure on their profit margins, adds the academic. The real estate market will also be affected. “The stock and real estate markets move hand in hand over cycles without it being a perfect positive correlation,” he says.
To take up Mr. Rancourt’s idea that quantitative tightening causes the opposite effects to those caused by qualitative easing, we must therefore expect from now on a contraction in the price-earnings multiples of equities, a rise bond rates and greater risk aversion on the part of investors.
We have seen this since the spring with the spectacular fall in bitcoin, a risky asset, and the attraction of the American dollar, an asset considered to be safer. The greenback appreciated strongly against a basket of currencies.
“People with low risk aversion will now prefer to put their money, for example, in term deposits or fixed income securities [donnant un rendement de 2, 3 ou 4 %], said M. Rancourt. As a result, there will be a drop in prices in financial markets like stocks. »
Before the tightening of monetary policy, this alternative solution did not exist, argues the economist. Almost everyone had to fall back on the stock market to get a return, which contributed to its high cost.