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I read that the Fed’s stimulus last March has contributed to a spectacular rally in stock markets. And indeed S&P500 has increased a lot since March.

But how does the mechanism work? How does the fact that central banks are buying more US treasuries help the stock market to rally?

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  • $\begingroup$ Duplicate of economics.stackexchange.com/q/37982? $\endgroup$
    – user4020
    Aug 3, 2020 at 5:50
  • $\begingroup$ I cannot see any explanation of the mechanism by which the FED intervention affects stock markets. Can you please provide more clarity? $\endgroup$
    – Diuoo
    Aug 3, 2020 at 9:16
  • $\begingroup$ @d'Halluin this is not duplicate. Your question was about how exactly the last round of stimulus affected stock market. Actually even worse it was about which opinion of two economists about the last round of the stimulus was more correct. That cannot be answered without opinions as it requires empirical study of what was the effect of last stimulus on stock prices which is unlikely to be forthcoming for at least 1-3 years. However, Q of Di EffeDue is about general mechanism. As I read it this user is not asking about the effect of March stimulus but $\endgroup$
    – 1muflon1 ♦
    Aug 3, 2020 at 10:52
  • $\begingroup$ about what kind of relationship there is between stimulating economy and stock market in general - that is completely different question on which actually some actual research exists. $\endgroup$
    – 1muflon1 ♦
    Aug 3, 2020 at 10:52
  • $\begingroup$ Author didn't cite his source for "I heard that". But Jeffrey Sachs claimed this. See economics.meta.stackexchange.com/q/2026. Author — do you want to add that quote to your post? $\endgroup$
    – user4020
    Aug 22, 2020 at 22:13

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If, as part quantitative easing, a central bank buys government bonds, it might affect prices of other assets positively via arbitrage and the so-called portfolio rebalancing effect. There are obviously several factors at play, but I focus on that one.

If there is more demand for government bonds via QE, bond prices increase, and their yields fall. Assume you have a portfolio of bonds and stocks, QE will then lower the expected yield of bonds relative to stocks. So you may want to sell some of your bonds (at the new higher price, too) and reinvest the money into stocks, that is, you rebalance your portfolio.

If everybody does that, prices of stocks can rise significantly, and largely independently of how stocks are expected to perform, as its about the relative return (with respect to bonds), not about the absolute return. The same applies to prices of other assets, as investors usually have many more asset classes in their portfolio than just government bonds and stocks. Risk management policies or requirements can dampen the effect for certain institutions (for example insurers).

The effect can be exacerbated if institutions take advantage of low interest rates and take out loans to invest in existing financial assets, rather than lending forward to businesses for investment into the real economy as intended by the central bank.

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If there were economic laws that could be used to determine the level of the stock market, why would people post them here, and not use these rules to make money themselves? (This leads ti the Efficient Markets Hypothesis).

Stock prices are what investors are willing to pay. If investors believe that practically anything causes the price to go up, they will bid up prices. It does not matter whether these beliefs make sense.

In this case, the premise is that Fed stimulus will cause the economy to grow faster, and thus profits are likely to be higher.

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  • $\begingroup$ Isn't it the case that after the fed announces the (unexpected) stimulus, then under EMH then markets snap to the correct evaluation? I don't think EMH prevents the fed from triggering increased stock prices. $\endgroup$
    – RegressForward
    Jul 2, 2021 at 18:20
  • $\begingroup$ If there were a simple law between the Fed’s actions and stock prices, it would generate arbitrage opportunities between equities and bonds that we don’t see in the real world. $\endgroup$
    – Brian Romanchuk
    Jul 4, 2021 at 0:12

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