Monetary Policy and the Stock Market
To illustrate just how much of a factor central banks are in setting stock prices, we only need to go back to late 2018 when stocks plunged on the Fed’s turn toward quantitative tightening or its recent actions to steady the markets during the global pandemic meltdown.
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Monetary Policy and the Stock Market
It’s no secret that central banks play an influential role in the direction of the stock market. To illustrate just how much of a factor they are in setting stock prices, we only need to go back to late 2018 when stocks plunged on the Fed’s turn toward quantitative tightening or its recent actions to steady the markets during the global pandemic meltdown.
The Good, The Bad, and Preventing the Ugly
A study published by the Bank for International Settlements, “Large Central Bank Balance Sheets and Market Functioning,” attempted to better understand the impact of central bank policies on market functioning, specifically those following the Credit Crisis.
Here are some highlights of its findings:
- Central bank balance sheet expansion had mostly positive effects on market functioning, especially in the early phases. Emergency lending programs eased market strains, while purchases of bonds largely improved the bonds’ underlying liquidity.
- Negative impacts were generally transitory and tended to be associated with elevated asset scarcity, which, in some instances, resulted in lower bond liquidity.
- Policy actions also had the effect, in some markets, to reduce market-making and investor participation, which was more pronounced over longer periods of time and less visible until balance sheet normalization.
- Central banks did implement mitigation strategies to avoid some of these negative impacts.
There were also a number of lessons learned, including:
- It is best to undertake a gradual pace when purchasing assets and limit holdings relative to the market size.
- Transparency and predictability of actions help to minimize uncertainty, something Fed Chairman Jerome Powell has adopted as a core belief.
- Retain operational flexibility to respond to changes in market or liquidity situations.
- The unwinding of the balance sheet should be both predictable and gradual to provide adequate time for investors to prepare and adapt to. For now, given the market’s 2018 response to quantitative tightening, this fine-tuning remains elusive.
The late legendary money manager Marty Zweig famously advised investors not to fight the Fed. He believed that monetary policy and the trend in interest rates was the dominant factor in influencing the market direction. This remains as true today as when he said it 50 years ago.
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