Demystifying the economy |  What are the effects of monetary tightening on financial and real estate markets?

Demystifying the economy | What are the effects of monetary tightening on financial and real estate markets?

Every Saturday, one of our journalists answers, in the company of experts, one of your questions about economics, finance, markets, etc.

Posted yesterday at 6:00 am

Andre Dubuc

Andre Dubuc

Good morning. From what I understand, low interest rates and monetary easing by central banks have fueled the rise in stock and real estate markets. Interest rates are going up. What about monetary easing? What is the effect of monetary tightening on the market downturn?

Gael Le Corre-Laliberte

“The answer is yes, monetary tightening will have effects on financial markets,” argues Olivier Rancourt, an economist at the Montreal Economic Institute who was asked to answer our reader’s question.

Essentially, monetary tightening will cause the opposite effects to those created by monetary easing, Mr Rancourt warns.

A bit of history: During the pandemic, the Federal Reserve and the Bank of Canada slashed their key rates and bought phenomenal amounts of government bonds with the goal of flooding financial markets with liquidity and keeping long-term interest rates lower. possible. Speed.

“A firefighter has never been criticized for using too much water,” Stephen Poloz, then Governor of the Bank of Canada, justified in the spring of 2020.

Bankers have given the name of quantitative easing to the massive purchases of government bonds, a measure that the Fed had already used during the financial recession of 2008-2010.

A more direct way of explaining quantitative easing is to say that central banks control the level of long-term interest rates by printing money out of thin air and using it to buy government debt.

The strategy was a success as the economy did not collapse during the pandemic, despite the lockdown.

However, the medal has its reverse. Central bank balance sheets have grown dramatically with all the bonds they have had to buy. Some also argue that the money-printing strategy has fueled a resurgence in inflation the likes of which has not been seen for at least 30 years.

There have been other effects, Incrementum AG notes in a recent report titled Stagflation 2.0. Market multiples have skyrocketed with all this influx of money in search of a limited number of investment opportunities. Investors have taken a risk. Bond yields across all categories fell, including corporate and junk bonds. In Canada, house prices have skyrocketed.

the wind has turned

Today the tide has turned. Inflation has become enemy number one. Central banks have raised their reference rates again. They have also started, or will soon, resell bonds on the market or simply be redeemed at maturity without buying new ones. By doing so, they will take money out of the economy, hence the term “quantitative adjustment.”

Commercial banks will react, Rancourt explains, by seeking liquidity elsewhere, by raising interest rates on deposits.

“If the Bank of Canada buys fewer bonds, there is some upward pressure on interest rates on long-term 5- to 10-year bonds,” adds Jean-François Rouillard, a professor in the Department of Economics at the University of Sherbrooke. Usually, when interest rates rise, it indicates a possible upcoming economic downturn. »

With the increase in the cost of money, the cost of financing companies will necessarily increase, which will put pressure on their profit margins, adds the academic. The real estate market will also be affected. “The stock and real estate markets go hand in hand through cycles without it being a perfect positive correlation,” he says.

To pick up on Mr Rancourt’s idea that quantitative tightening causes the opposite effects to those caused by qualitative easing, we should therefore expect a contraction in equity price-earnings multiples from now on, a rise in bond rates and increased risk aversion on the part of investors

We have seen it since the spring with the spectacular fall of bitcoin, a risky asset, and the attraction of the US dollar, an asset considered safer. The dollar appreciated strongly against a basket of currencies.

“People with low risk aversion will now prefer to put their money, for example, in time deposits or fixed income securities [donnant un rendement de 2, 3 ou 4 %]said M. Rancourt. As a result, there will be a drop in prices in financial markets such as stocks. »

Before the tightening of monetary policy, this alternative solution did not exist, argues the economist. Almost all had to turn to the stock market for a return, which contributed to their high cost.

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