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Introduction

`. Analyze the effect central bank easing during the Great Recession had on global equity markets.

After 10 useless actions of federal funds rate cut from 5.25% to 0.25%, the Federal Reserve turned to quantitative easing for the first time in history. Under the high financial pressure caused by funding for several institutions that were on the verge of bankruptcy, the Federal Reserve announced the enforcement of QE1 In late November 2008, the Federal Reserve started buying $600 billion in mortgage-backed securities. By March 2009, it held $1.75 trillion of bank debt, mortgage-backed securities, and Treasury notes; this amount reached a peak of $2.1 trillion in June 2010. [footnoteRef:1] After the introduction of QE1, the US economy recovered quickly. GDP growth rate rose from -8.9% in the fourth quarter of 2008 to the first quarter of 2010 of 2.3%. Over the same period, the United States also got out of the plight of deflation. CPI went from zero growth in December of 2008 to a positive change of 2.3% in March of 2010. With the rapid recovery shown by rises in economic indicators numbers, the effectiveness of QE1 in boosting the US economy was proved. [1: Quantitative Easing, last modified on 25 November 2019

https://en.wikipedia.org/wiki/Quantitative_easing#US_QE1,_QE2,_and_QE3]

Dow Jones – DJIA – 100 Year Historical Chart

With QE1 providing liquidity in finance market, the US equity market recovered after February of 2009, driving better performance globally. The chart shows that the Dow Jones Industrial fell to the lowest soon after the start of 2009. However, the New York stock market recovered strongly over the next nine months with injected liquidity. From March 9, 2009 to December 24, 2009, the Dow Jones index rebounded from 6547.05 bps to 10520.10 bps, up 60.7%. There were obvious rises in other indexes as well. As a result of globalization, equity markets in other developed countries also made good performance since the lowest point at the beginning of the year.

At the beginning of 2009, the British economy were in deep recession, and the decline of the London stock market did not stop. In early March, the FTSE 100 in London hit a six-year low of around 3,530 bps. Since then, the London stock market has recovered gradually. By the end of the first half, the FTSE 100 had risen to about 4,250 bps, having recovered much of the depression since the start of the year. As the economy gradually improved, the stock market acted positively. On December 24, it closed at 5,402.41 bps, increased 18.4% from the start of the year and nearly 50% from the lowest in early March.

In continental Europe, French stocks have experienced a drop and rebound. Affected by the subprime crisis, the French economy experienced four consecutive quarters of contraction from the second quarter of 2008, and the decline of the CAC 40 continued until the beginning of March 2009. The French economy began to show signs of recovery in April, and its stock market began a huge rally lasting more than half a year, up about 50%.

However, as the Federal Reserve continued its quantitative easing, Asian countries are showing signs of overheating. It seemed like that bubbles occurred in real estate and equity markets. The Nikkei 225 stock average closed at its lowest level in more than 26 years on March 10th, before slowly recovering. The equity market in Tokyo has rebounded on the back of the governments regulation and the improving global economic environment. In China, the SSE Composite index had fallen to 1,664.93 bps at the end of October 2008. Later, Chinese stock market experienced the sharp rise in 2009. By early August, the SSE Composite index had reached 3478.01 bps, which was a rise of more than 100%.

Through the equity market data of various countries after the Federal Reserve carried out easing operations in the United States, it can be summarized that the recovery in US equity market under the effect of QE1 stimulated the growth in global equity market as well. The reasons laid under international trades and investments. As an unconventional monetary tool, central banks quantitative easing was basically an operation that injects money into the economy to provide liquidity, in ways of purchasing financial assets and increase the length of balance sheet. Because of the implementation of quantitative easing, the increase in the money supply had led to a depreciation in the dollar, which was helpful to stimulate US exportation. With weaker dollars, it became easier for the United States to reduce its trade deficit and unemployment rate, thus provide acceleration to economic recovery. The US equity market was boosted with super low interest rates brought by QE1. As the world’s largest economy with the global reserve currency, implementing the quantitative easing monetary policy in the United States quickly mitigated the impact of economic crisis. If without this position, quantitative easing would either be useless or force the countrys economy into the other extreme of severe inflation.

To other countries, the action also had impacts on global capital flow and import-export trades, influencing equity markets all over the world. Investors who owned shares of US companies profited from the US equity market surge, and the money earned was brought back to their own countries. Although depreciation made it beneficial for US to export to the rest of the world, countries that exports necessities to the United States could still profit because of the equity market growth. A surge in stock market meant more consumer spending and business investment.[footnoteRef:2] Those companies earned more because of US consumers spending, and the profit they earned contributed to their home countries stock market growth. Thus, QE1 during the Great Recession caused the upsurge in both US stock market and equity markets all around the world. [2: Market is Up, Updated June 28th, 2019 https://www.investopedia.com/terms/m/marketisup.asp]

a. What does the unwinding of central bank balance sheets imply about equity markets for the coming years?

Balance sheet unwinding is the act of a central bank reducing the size of its balance sheet. By selling the loans it held or stopping reinvesting maturing debts, the Federal Reserve can withdraw money directly from US economy. Unwinding is a more effective tightening than raising interest rates. The balance sheet of the Federal Reserve began to expand significantly after the implementation of QE at the end of 2008, from $2.12 trillion to the end of October 2014, when it withdrew the easing. The balance sheet reached a peak of $4.47 trillion. Reducing the length of balance sheet means the release of long-term high-quality assets and the absorption of speculative funds, stabilizing the financial system. The unwinding action can flexibly affect the long-term interest rate and lead to the upward movement of the yield curve. It will help to restore the credibility of the dollar and reduce the negative externalities of the Federal Funds rate hikes. Also, it can provide high-quality US dollar denominated assets to the world, helping to alleviate the shortage of safe haven assets in Europe, Japan and other countries. It will mitigate the impact of Federal Funds rate hikes on countries with easing monetary policy as well.

[image: https://wolfstreet.com/wp-content/uploads/2018/11/US-Fed-Balance-sheet-2018-11-01-overall.png]

According to the expected balance sheet unwinding started from 2017, there will be less than half of the amount of dollars in the market and demand will exceed supply. The dollar will become more valuable, having more purchase power. At the same time, the interest rate rise will absorb dollars back to the United States, as foreign market began to hold less dollars. The dollar appreciates, and other currencies depreciates.

The Federal Reserve uses QE to signal to the market that interest rates will remain low in the future and uses balance sheet reduction as the opposite signal of raising interest rates. Unwinding the balance sheet is a disguised interest rate increase to attract funds into US stocks and bonds markets, which is negative for gold. Historically, balance sheet shrinking had a great impact on the US economy, as well as its stock market. In 2008, an author analyzed that fears about rising prices, combined with threats of trade wars, has Wall Street acting nervous. The S&P 500, after hitting record levels in January, is down 1.5 percent on the year.[footnoteRef:3] With fear in the market, the stock market changes cannot be unknown exactly, but surely negative. The high interest environment might hurt investors with increased volatility in equity market, making them less willing to put capital in risky assets. The downward sloping of stock market was proved with this decrease in S&P during latter part of 2018. [3: Taylor Tepper, The Feds balance sheet is shrinking. How does it affect you?, April 6th, 2018]

[image: us stock market 2019„þGÓœ]

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