The QE boom in stock markets

What fuels stock prices also amplifies fragilities in the financial markets.

The Fed will have to respond to financial turbulences through additional asset purchases to assure investors in terms of the liquidity.

Markets would enter a turmoil in any bad news when the Fed does not go on quantitative easing. Unless economy recovers in the near term, a downfall is inevitable both in stock and bond markets.

A constraint over the Fed's commercial security purchases is the guarantee provided by the Treasury.

As Zoltan Pozsar (2011) stated, bank deposit accounts are an option to store value for amounts below the government insurance limit. For funds over the limit, deposit accounts are not secure enough. For this reason, institutional cash pools such as non-financial corporations, asset managers and pension funds lend in return of an asset backed security (ABS). Backed by collateral, ABSs provide the additional security for cash pools.

Though, the default risk is not totally eliminated due to the deviations in collateral prices. Collateral might fall short in compensating debt in case of a sharp fall in its price. To meet the demand for safe assets, financial manufacturers divide securities into tranches. The probability of loss significantly falls for senior tranches as junior tranches primarily absorb losses in return of a higher interest. A portion of the debt thus becomes more secure by transferring the default risk to the other portion.

As Zoltan Pozsar (2011) articulated, there is an unmet demand for safe assets in the world. The negative interest rate trend of treasuries has been signaling the rising demand. The safe asset supply cannot be easily raised as the collateral supply is limited. Through quantitative easing, central banks further suck safe assets leaving investors with riskier portfolios. When investors are left with no other option, they are obliged to buy junk bonds, the junior tranches of safe assets, which are below the investment-grade. When the default risk inherent to portfolios rises, stocks also become an investment option for many actors. Quantitative easing of central banks hence fuels stock markets.

Investors are well aware that they sit on a crazy credit risk. The bullish trend in stock markets will continue until the next bad news. When negative growth and higher delinquency rates raise anxiety in the markets, investors will once again turn to the Fed. The Fed will have to respond through additional asset purchases to assure investors in terms of the liquidity. Once again, absorption of less risky assets by the Fed will further push investors to risky assets such as junk bonds and stocks.

It is not easy to predict where this mania will end. It depends on how long the Fed will continue to expand its balance sheet. Will they buy everything in the market? Theoretically, they can buy all stocks and bonds. Through the demand created by the Fed, any asset's price can continue to rise.

The credit risk in the Fed balance sheet incrementally rises. A constraint over the Fed's commercial security purchases is the guarantee provided by the Treasury. When securities owned by the The Fed default, the Treasury will compensate losses via the funds authorized by Congress. At some point, the Treasury will need the authorization of additional funds to guarantee additional asset purchases by the Fed.

Markets would enter a turmoil in any bad news when the Fed cannot go on quantitative easing. Unless economy recovers in the near term, such a downfall is inevitable both in stock and bond markets.