Why Bull Markets If QE Does Not Work? A New Perspective
We know that QE does not work because reserves are not lent out.
We also know that this invalidates narratives that attribute rising stock/gold/etc. prices to the explosion in bank reserves.
Why then the massive bull markets in these assets?
First, and most importantly, as mentioned many times before, is Paradigm. Belief is a powerful force that shapes our thinking after all.
But, is paradigm really all there is to how markets trade?
Of course not.
Paradigm is simply the spark (albeit a very powerful spark) that gets people brave enough to start buying financial assets again after a frenzied selloff.
This is especially relevant in the era of the central bank, where market participants have, over the years come to firmly believe in ideas such as the “Greenspan Put”, that became the “Fed Put” after Alan Greenspan’s retirement.
Initial buying based on participants’ belief in central bank action begets more buying, pushing prices higher.
Rising prices force shorts to cover, which further fuels the nascent rally, and “market recovery” narratives, previously whispered, are now discussed more openly and with increasing conviction.
Optimism grows, drawing in previously skeptical buyers.
Also, banks and brokers start feeling comfortable taking counterparty credit risk again, making credit more widely available. This allows folks with access to credit to borrow and leverage purchases, especially in markets where leverage is crucial to purchasing assets, like real estate.
Asset prices remain elevated while the economy catches up, giving enough “fundamental” support to asset prices. For example, a sustained period of strong corporate earnings that gives analysts, the media, and market participants a nexus to construct bullish narratives around.
At this point, ebullience is in vogue, and bearishness is treated with cries of “broken clock!” – in other words, a proper bull market.
Ultimately, all of this comes down to confidence, simply because modern capitalism runs on confidence.
In the case of traders and investors, they have come to place an increasing amount of confidence in central banks over the last few decades, even as central bank policy has evolved to the point where intervention is now the norm.
Consequently, the markets’ perceived omnipotence of central banks’ action has come to dominate their paradigm and narratives.
Just as it is with markets, confidence is crucial in the real economy.
Businesses must be confident enough in their future prospects to take out new loans to expand their operations, thereby creating new money in the economy. Corporations must be confident enough in the state of the global economy to expand business lines, engage in product development, and hire more people.
Of course, the financial markets and the real economy are interrelated parts, and what happens in one can feed into the other.
However, this relationship can at times blow hot, and at other times blow very cold.
An excellent example of the former is the bull market leading up to the Great Financial Crisis of 2008, where both asset prices and the economy grew strongly.
For the latter, a good example is today’s Covid economy, where the US labor market continues to struggle even though interest rates are mired near 0% and stock markets are trading bubble-liciously.
Confidence, however, takes time to build, much longer than it takes to be lost.
Considering QE’s failings, perhaps that’s the secret ingredient to bull markets and strong economies – time.
Time for confidence to recover, time for balance sheets to be repaired, and time for counterparties to rebuild trust and do business together again.
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