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Low-Interest Rates & Quantitative Easing:Effects on Financial Markets Introduction: During the early 2000s, Japan’seconomy was fighting against deflation triggered by the economic collapse inlate 1991. At that time, the Bank of Japan lowered short-term interest rate close to zero inorder to stimulate economic growth. Even withlow-interest rates, Japan’s economy was still suffering from stagnant growth.Therefore on March 19th, 2001, the bank of Japan adopted Quantitative Easing.

This flooded banks with excess liquidity in order to promote consumer lending.The Bank of Japan increased their asset holdings from 5 trillion Yen to 35trillion Yen between the years 2001 to 2004. The results of Quantitative Easingthat Japan utilized took longer than expected to demonstrate results butultimately failed to get rid of persistent deflation. Only after the greatrecession, other countries such as the United States, United Kingdom, and the Eurozone embarked on Quantitative Easing because the risk-free short-term interest rates wereclose to zero. The Federal Reserve beganQuantitative Easing in November 2008. Manyeconomists criticized the decision to implement Quantitative Easing, due to Japan’s failure a few years prior to the financial crisis. The 1st round of QuantitativeEasing was targeted toward mortgage-backed securities, in order to directlycombat the collapse of the housing market, by purchasing $600 billion and $100billion in other debt with Fannie Mae and Freddie Mac backing it.

By March2009, the Federal Reserve reached $1.75 trillion in assets, and the economy wasstill suffering which lead to an additional $750 billion in mortgage-backedsecurities, $100 billion in Fannie and Freddie debt, and $300 billion oflonger-term Treasury over the next six months.By June 2010, the Federal Reserve ended QE1 when Ben Bernanke saw the economy starting to turn around, but afew months later he hinted QE2 because the economy was sliding again. QE2lasted from September 2011 to December 2012, when the Federal Reserve would buy $600 billion of treasury bills and bonds. The Federal Reserve directly boughtsecurities from banks to artificially lower interest rates, which wouldtheoretically increase the money supply in the economy and boost inflation.

However, the banks didn’t increase lending because they couldn’t findcreditworthy individuals after the recession. The Federal Reserveresponded by purchasing $30 billion a month inlonger-term Treasury Bonds, which wouldforce investors back into mortgage-backed securities. On September 13, 2012,the Federal Reserve implemented QE3, buying $40 billion worth ofmortgage-backed securities and $85 billion worth of Treasury Bonds a month. TheFederal Reserve had the intentions of setting theinflation rate target of 2%,stimulating a greater economic expansion, and lowering the unemployment ratebelow 6.5%. It also included the mandate of lowering the short-term interest rates at zero until 2015. Although the Federal Reserve has announced that they ended their assetpurchases, they are still reinvesting the interest earned on Treasury Bonds, still increasing their balancesheet. On Setempber 2017, Federal Reserve Chairwoman Janet Yellen stated thatthey will unwind their balance sheet beginning October 2017.

Despite theirannouncement, their reduction of their balance sheet is less than announced.Problem Identification: With the implementation of low-interest rates andQuantitative Easing that Central Banks all across the world are utilizing toincrease inflation target, there are numerousmajor downsides risk of prolonged uses of these monetary tools. For example, ifthe economy experiences another severe downturn, the Federal Reserve won’t have the monetary tools to slash rates to stimulate inflation during a recession. Also, having low-interest ratesaffects savers negativity, especially pension plans, because their risk-freerate is not enough to overcome the inflation rate. This cause money to flowfrom risk-free assets and into equities, real estate and other and higher riskassets, artificially creating bubbles if left unchecked. It also distorts thetrue valuation of assets, such as discounted cash flow models and CAPM.

WithQuantitative Easing, it’s an unconventional monetary policy that has never beenimplemented and tested on a wide scale in the history of financial markets. Itdrives the debt to GDP ratio immensely, artificially drives low yields in thebonds market, increases household debt while household income has beenstagnant, and last but not least, it could cause hyperinflation if not regulatedcorrectly. Going back to interest rates, since the creation of the Federal Reserve in 1913, almost everydepression or recession have been foreshadowed by interest rate hikes and an inverted yield curve. Literature Review: In order to prove the correlation between the Federal Reserve intervention of interest rates and expansion/recession cycles, the data, and resourcesused for this analysis is derived from the Federal Reserve Economic Data, St.

 Louis Fed, US Treasury Database, Bloomberg Terminal database and otherreliable and credible sources for extracting data from. In addition toextracting data sets, gathering information regarding the understanding of bondyield curves and other fundamental finance topics from credible textbooks andarticles to extrapolate the effects of prolonged use of QE and low-interest rates.Hypothesis Review: As stated earlier, by analyzing and interpreting therelationship between the Federal Reserve, interest rates, and quantitativeeasing can cause expansions and recessions in the economic business cycle. Bycomparing the changes of increases and decreases of interest rates by theFederal Reserve relative to the equity markets, most notably the S 500, there’s a strong relationship between the two. By usingthe treasury bond data, bond yield chart, and federal reserve balance sheetdata to prove the correlation. Data Analysis: Inorder to utilize the data from thosesources to format a conclusion, knowing the importance of eachquantitative and qualitative data is vital. A normal yield curve, figure 1, is the yield curve shape that forms during normal market conditions, where investors generally believe that there will be no significant changes in the economy, such as in inflation rates, and that the economy will continue togrow at a normal rate. Investors expect higher yield for fixed income in longer maturities and lower yieldfor fixed incomes for shorter maturities.

 This is a normalexpectation of the market because short-term instruments generally hold less risk than long-term instruments; the farther into the future the bond’s maturity, the more time and, therefore, uncertaintythe bondholder faces before being paid back the principal. To invest in oneinstrument for a longer period of time, an investor needs to be compensated forundertaking the additional risk. A flat yield curve, figure 2, curves indicate that the market environment is sending mixed signals to investors,who are interpreting interest rate movements in various ways.

In such anenvironment, it is difficult for the market to determine whether interest rateswill move significantly in either direction farther into the future. A flatyield curve usually occurs when the market is making a transition that emitsdifferent but simultaneous indications of what interest rates will do. In otherwords, there may be some signals that short-term interest rates will rise andother signals that long-term interest rates will fall. This condition willcreate a curve that is flatter than its normal positive slope. When the yield curve is flat, investors can maximizetheir risk/return trade-off by choosing fixed-income securities with the least risk,or highest credit quality.

In the rare instances wherein long-term interestrates decline, a flat curve can sometimes lead to an inverted curve. Aninverted yield curve, figure 3, are formed during extrememarket conditions, a majority of the time during a recession, where the short-termmaturities yields are higher than the longer term maturities yields. The marketsexpect for interest rates to decline, for long-term bonds.

 By locking in a yield for a long-term bond, if the yield decrease, the value of bond increases. The significantof discussing the bond yield curves is thefact the Federal Reserve dictates and influences the short-term end of the curve. If the Federal Reserve raises the short-term yields too quickly, this can cause the yield curve to invert, leading to aneconomic recession. The treasury yield curve inverted before 1929, 1981, 1991, 2000 and 2008 financial crisis. In recent times, the first inversion of the bond yield occurred on December 22, 2005, two years before the greatrecession.

 During this period, the Federal Reserve, worried about an asset bubble in the housing market, had been raising short term interestrates since June 2004. By the end of December, it was 4.25%. That pushed theyield on the two-year Treasury bill to 4.40%. On the opposite spectrum,the yield on the seven-year Treasury note lagged behind the curve, going for 4.

39%. This caused the first inversion in the bondyield curve. By December 30, the discrepancy became worse. The two-year Treasury bill returned 4.

41%, while the seven-year note yield fell to4.36 %. The 10-year Treasury note yielddropped to 4.

39 %, below the yield for the two-year bill. A month later (January 31, 2006), the Fed had raised the shortterm interest rates again. The two-year bill yield rose to 4.54 %, which was higher than the seven-year yield of 4.49%.

Despite past economic warnings due to inverted yield curve,the Fed decided to continue to rase rates, reaching a 5.25% in June 2006. On July 17, 2006, the inversion worsened again when the 10-year note yielded 5.07%, less than the three-monthbill at 5.

11%. The bond yield curveremained inverted until June 2007. By September 2007, the Fedfinally became concerned and started lowering theshort-term rates, but it was too late.

 It loweredthe fed funds rate to 4.75 %. It was a 1/2 point,which was a significant drop. The Fed meant to send an aggressive signal to themarkets. The Fed continued to lower the rate ten times until it reached zero bythe end of 2008.

The yield curve was no longer inverted, but it was toolate. The economy had entered the worst recession since the Great Depression.This is one of many times when the Federal Reserve failed to realize a recession before it was too late.

The graph, figure 4 above,shows the differences of the 10-year treasury yield minus the 2-year treasury yield. When that value is below 0%, it signifies an inverted yield curve. The grey bars proceeding the negative yieldsrepresents the economy during a recession. There’s a strong relationship, with the inverted yield curve foreshadowing a recession by a factor of one to twoyears. This leads to therelationship between short-term interest rates and net interest margin on loansfrom banks. The graph, figure 5 on the previous page, shows the relationshipbetween the 1-year treasury and net interest margin for all U.

S banks. Largedeclines in the yield on Treasury securities during the recessions of 1990-91, 2001 and 2007-09coincided with substantial increases in netinterest margins in the short term, as net interest margin hasn’t caught upwith real rates. As market interest rates continued to fall after therecessions, however, net interest margins eventually also fell. During periodsof low rates, most notably post-2009, while it stimulates equity and housingmarkets, net interest margin for banks declines rapidly, which hurts bankearnings. By taking a regression analysis of the data points from figure 5,(table 2) short-term interest rates and net margin interest has a correlationof -0.582, which is a decently strong correlation.

Leading back to interestrates and it’s relationship to recessions, figure 6, is a chart from MerrillLynch which compiles the past interest rate hikes from theFederal Reserve since 1913 and compared it to economic depressions and recessions. This could be a strongindicator in the future if the bond yield curve starts to invert. Currently, the bond yield curve, figure 7, is the flattest since 2005.

Withthe FOMC expecting to raise rates three times in 2018, with aprojection of 25 bases points for each hike, could easily invert it by 2019,which is why the Federal Reserve has been slow to raise hikes during this expansion cycle. The chart, figure 8, is the relationship between the S&P 500 and quantitative easing. Clearly shownin the chart, each round of quantitative easing drove equities up massively,only when the Federal Reserve announced that they would stop QE, markets had major pullbacks. Inaddition, figure 9, shows the relationship between the S&P 500 and U.STreasury securities held by the Federal Reserve.

 As the balance sheet increased substantially, so has equity prices. The main driver of the stock market isn’tearnings but from quantitative easing. Results Interpretation: With the dataand research gathered, concluding that the Federal Reserve is a key catalyst for creating economic bubbles andrecessions.

By artificially manipulating the short-term interest rates and morerecently, using quantitative easing to purchase bonds, MBS and even equities inthe case of the Bank of Japan, instead of letting the free market price at fairprices, it has caused a massive rotation of cash from savers to invest inequities to chase yield. This has led to an economic bubble in both the equityand housing markets, both in the past and present. With the Federal Reserve expecting to raise interest rates three more times in 2018, two in 2019and once in 2020, this could easily invert the yield curve, which has been an ominous indicator to market corrections and recessions.

With quantitative easing providing cheap money and also lowering long-term bondyields, while it created one of the largest bull markets in history, it a newfinancial concept which has never been tested. In addition, with the FederalReserve and other Central Banks reducing their balance sheet, economists arenot sure how it would affect financial markets, most likely in a negativemanner. Recommendations: With equity, housing and bond markets at new highs andbooming, along with the lowest unemployment numbers in years, suggesting tohike interest rates quicker than expected, but not as quick in the past wouldbe the optimal solution. In addition, reducing the Federal Reserve balancesheet would also be suggested.Having interest rates low for so long could limit the recovery of the nexteconomic recession.

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