Quantitative Easing and the U.S. Stock Market

June 15, 2011 | Doug Oest, CAIA, Partner

In an attempt to stimulate economic growth, the Federal Reserve (the “Fed”) has used multiple monetary policy tools in the past few years: reducing short-term interest rates to virtually zero, introducing numerous facilities to stabilize specific areas of the market, and implementing quantitative easing (“QE”) programs. Announced in late 2008, the first round of quantitative easing (“QE1”) involved the purchase of $100 billion of government sponsored entity obligations and $500 billion of mortgage backed securities. After its effectiveness was reconsidered, QE1 was expanded in March 2009 with the Fed purchasing $1.25 trillion in mortgage backed securities and up to $300 billion of longer term Treasury securities. This massive increase in the Fed’s balance sheet is evident in the chart above, which depicts the securities held outright by the Fed – along with movement of the S&P 500 Index – since 2007. The equity markets rallied more than 50% from the inception of QE1 to its completion; however, once QE1 purchases stopped and the market experienced several troubling issues including riots in Greece and the “Flash Crash” of May 6, 2010, the equity markets experienced a sharp pullback.

In late August 2010, Fed Chairman Ben Bernanke hinted at a second round of quantitative easing (“QE2”) during a speech in Jackson Hole, Wyoming. After the official announcement of an additional $600 billion in longer term Treasury purchases, Chairman Bernanke wrote about QE2 in an op-ed piece for the Washington Post. He noted that QE programs have “eased financial conditions in the past and, so far, look to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action”. He continued, “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion”. Since the Jackson Hole speech in August 2010, the equity markets rallied nearly 30% through the end of April, 2011.

However, with the culmination of QE2 approaching at the end of June, a recent round of subpar economic news and a decline in the equity markets that erased nearly all of 2011’s year-to-date gains, eyes have turned backed to the Fed to see if additional policy measures will be implemented. During his speech on June 7th, Chairman Bernanke failed to hint of another round of QE as he did in his Jackson Hole speech. Following the speech, several major financial institutions, including Goldman Sachs, JP Morgan, and PIMCO, have stated that the Fed is unlikely to initiate another round of QE, which would leave the markets without ongoing support from the Fed for the second time in nearly three years.