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How Monetary Tightening Could Affect the Stock Markets

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Monetary tightening

The ultra-loose monetary policies that have been in vogue for many years have helped jack up prices of all the asset classes. Real estate prices, as represented by the S&P CoreLogic Case-Shiller US National Home Price Index, have risen 36% during the past five years, and the stock market (QQQ), represented by the S&P 500 Index (SPX-INDEX) (SPY) has surged a whopping 91.5%. Lower interest rates and easy liquidity were the main drivers fueling a sharp rally in stocks (DIA) (VOO) and real estate.

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Higher cost of borrowing

But as the central banks of developed markets started unwinding their easy monetary policies, stocks may have felt the effect. After increasing interest rates by 0.75 percentage points in 2017, the Federal Reserve now plans to raise rates three times in 2018 and two times in 2019. It’s also in the process of shrinking its balance sheet from the current $4.5 trillion to below $3 trillion by 2020. The European Central Bank, the Bank of Japan, and the Bank of Canada may also raise their interest rates in 2018, and the Bank of England may follow suit.

With less liquidity in the financial system, banks (XLF) could have less funds to lend, which ultimately could lead to higher borrowing costs for corporations and consumers. The rising yield could eventually result in portfolio rebalancing in favor of higher-yielding bonds, while risk assets such as stocks could see lower allocations, possibly resulting in higher market volatility.

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