The better explanation for why the stock markets have been surging – they are up about 3 per cent already this month – lies with the usual suspect.
It would appear that it has been the US Federal Reserve Board’s response to the seizure in the US "repo" market last September that has driven sharemarkets to new heights. Since that market froze in mid-September, with rates soaring as liquidity disappeared, the US sharemarket has risen almost 11 per cent.
Repo markets provide short-term liquidity to companies and institutions in exchange for high-quality collateral such as US Treasury bills. The borrower sells the securities for cash while simultaneously contracting to buy them back in the near term – as little as 24 hours – for a slightly higher price.
The Fed did two things in response to the malfunctioning of the repo market.
It injected and has continued to inject massive doses of short-term liquidity, providing at least $US120 billion ($175 billion) of overnight and 14-day cash each month in exchange for high-quality collateral through its own repo facilities.
It also, moreover, started buying Treasury bills at a rate of $US60 billion ($87 billion) a month.
It has done so because it believes that, as it reduced the size of its balance sheet by allowing securities it purchased during its three big post-crisis quantitative easing (bond and mortgage-buying) programs, bank reserves – the cash they hold with the Fed – have also fallen to levels too low to enable them to lend enough cash into the repo market.
The story is slightly more complicated than that because a strand of the explanation for the banks' inability to deploy their reserves is the post-crisis prudential reforms that force...