Despite the now numerous iterations of quantitative easing, the full effects of large-scale asset purchases aren’t fully understood by market participants or policy makers. After four years of experimenting in this new Petri dish, markets understand how liquidity is created, but not where that liquidity ultimately flows to. Arguably, as evidence by P/E multiple expansion, new highs on the major indices, high yield credit spread at all-time lows, and a still sluggish economy, many believe that much of this liquidity has found its way into risky assets as opposed to the broader economy.
If we take a step back for a moment, there are three potential adverse consequences from quantitative easing (QE):
- Future inflation
- Negative political and/or sovereign perceptions
- Asset bubbles
To date, two out of those three adverse consequences haven’t been a problem. On the inflation front, TIPS breakeven rates are range bound, precious metal prices are falling, and lagging measures of inflation via governmental statistics are tempered. Similarly, although there have been some negative headlines surrounding the risks of QE, by no means are these rumblings excessive or prohibitive to policy continuation. However, what may present an issue is the persistence of increasing asset valuations.
While many members of the Fed believe higher asset prices create a “wealth effect”, two recent bubbles suggest that the last thing policymakers need on their plate is another asset bubble. Finding the delicate balance between boosting wealth and not creating a new bubble suggests that the Fed will ultimately need to pullback on quantitative easing should price trends continue at their current pace. Thus, in a circular reference type of thought process, I worry that the regulator to higher equity prices may ultimately be higher equity prices in and of themselves. Said a bit differently, higher asset prices has the potential to cause concern for the Fed, resulting in a tapering off of quantitative easing, ultimately translating to a pullback in equity prices. Hence, higher equity prices may ultimately be the reason that central banks have to ease off of the pedal. Thus, in a “reflexivity” sort of way, rapidly rising asset prices may be bad for assets in the back of 2013 or 2014.
In today’s market environment, the name of the investing game is investing alongside the Fed. Naturally, one can then understand why the Federal Reserve “tapering” their quantitative easing is such a big deal. When the rules of the game change, it takes time for markets to understand the paradigm shift and transition from the easy liquidity from central banks. Our belief is that the Fed is well aware that it greatly influences markets and thus will try to make this transition as smooth as possible without pushing markets into bubble territory.