Two central banks may hold the fate of equity markets in their hands (page 1 of 2)

By Chris Tedder, Research Analyst, Forex.com

The US Federal Reserve

Over the last month or so there has been, and still is, significant hype surrounding the possibility that the Fed will act to simulate the US economy by engaging in another round of QE. Hence, when the Fed failed to pull the trigger at its August meeting many risk assets were hit by a wave of selling.

Yet, most equity markets were saved from a big sell-off by the Fed bluntly stating that further monetary easing remains a distinct possibility, which is a signal to investors that the Fed may let QE3 loose during its September meeting. In fact, many economists were already leaning towards further Fed action in September as opposed to August. However, we are not as sure the Fed will act, which creates room for disappointment and, in turn, downside for major equity markets.

Whilst we don't deny the fact that the US economic recovery is stalling somewhat, we also don't think the Fed is going to pull the trigger on QE3. Despite the recent downturn in US labour market data, the rest of the economy is still on a path to recovery, including the problematic housing sector. Furthermore, every time the Fed engages the printing press to bring down long-term interest rates the effect is diminished, we can see this by looking at the impact of QE1 compared to QE2.

Granted, the impact of the first round of QE is expected to yield more because it happened when there was greater economic distress in the market and, therefore, there was more room for improvement, but this doesn't completely explain the differences between the estimated economic benefits of QE1 and QE2. Actually, many studies suggest that the benefits of QE were more than halved the second time around, making the actual economic benefit of QE2 fairly minimal. Likewise, we expect this trend to continue if the Fed pulls the trigger on QE3 and, importantly, Fed officials are acutely aware of this.

The European Central Bank

In Europe, the European Central Bank (ECB) is at the front line as the region's defence against the spread of the debt crisis. The bank has interceded in the market on numerous occasions; most notably by purchasing bonds in the secondary market and lending money at very low interest rate (this is known as a long-term financing operation) in an attempt to ease borrowing costs for struggling debt laden nations.

Overall, the measures, combined with funds from the EFSF, have been effective in keeping the debt crisis relatively contained. Note, however, there is still a lot of uncertainty surrounding the ability of Europe to avoid a massive economic collapse, possibly involving a break-up of the Eurozone.

One of the biggest issues in Europe right now is the inevitability that Spain will require a bailout. Concern originates from the fact that the EFSF doesn't have enough funds to cover a full-blown Spanish bailout, at least until the ESM is ratified. But even then there is the distinct possibility that Italy will also require a bailout, despite the Italian government being against this idea as it would come with a lot of conditions, similar to the austerity measures imposed on Greece.

However, whilst it is understandable that these conditions would be unpopular in Italy, it is hard to see how they can be avoided. This is where the ECB can come into play. It can step in and start buying government bonds again in the secondary market, which would help bring borrowing costs for the aforementioned countries down.