Wednesday, April 8, 2015

What Really Happens to Asset Prices?

If you subscribe to the conventional dialog about the normalization of monetary policy by the Federal Reserve, the so-called ‘lift-off’ should be this summer or thereabouts. I’m not necessarily convinced that the timing is best, but I digress. The primary result of the Quantitative Easing programs utilized by the Federal Reserve was an enormous increase in excess reserves in the banking system. A secondary effect was the run-up in financial asset prices, as a result of the open market actions of the Fed to influence the levels of long-term interest rates. Economic Commentaries from the Federal Reserve Bank of Cleveland suggest that the target of Fed tightening will be the excess reserves within the banking system, and not necessarily interest rates from the onset.

When the vast amounts of liquidity that the banks hold starts to collectively dry up due to the change in the Federal Reserve’s stance on monetary policy, the transactions that have been supporting financial asset prices will begin to slow. At that point, what happens to asset prices? Equities prices on one hand, are at record highs and likely to drift higher. Without the technical demand from the banking system, the fundamental demand in relation to household savings levels will not be enough to keep equity prices at or above current levels.  Debt prices on the other hand, are at record highs and likely to drift higher. It is important to note, that the rebalancing effects of the Federal Open Market Committee’s (FOMC) actions in the debt markets to influence long-term interest rates pushed bond prices to now elevated levels.

Quantitative Easing was a necessary evil on the part of the Federal Reserve, as doing nothing would have been even less palatable. Now, we’ve arrived to the point of dealing with the aftermath and eventual unwinding of the policies. Without the implicit and at some points explicit support of the Federal Reserve, financial markets in the US and by extension the rest of the world would be forced to stop pretending. A more realistic picture of the economy may have a chance of emerging. Monetary policy unwinding does not necessarily turn into a market crash, it would simply effect a realignment of Wall Street with Main Street.

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