When it began, some thought it might not run its course. Now that it’s ending, there are those who think another installment is needed. The “it,” of course, is the Federal Reserve’s second round of large-scale asset purchases, better known as quantitative easing.
The lender of last resort will single-handedly have accounted for more than 80 percent of the Treasury’s coupon issuance from November through the end of June: $773 billion of an expected $946 billion of new cash raised through note and bond sales, according to Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.
What happens when that big buyer says adios? Prices should fall, or in this case, yields should rise, right? At least that’s what happens in a free market.
I suspect yields will rise, but not right away and not because of the termination of QE2. The economy’s current soft patch, in an otherwise unremarkable recovery, will be the driving force. Let me explain.
In a free market, a cutback in demand results in lower prices in order to allocate the supply.
This isn’t a free market. The Fed is a monopolist holding sway in the front end of the yield curve. It sets the price of the overnight rate, currently a range of 0 to 0.25 percent. Other short-term rates, such as those on Treasury bills and eurodollars, are priced off the fed funds rate.
Fed’s Long Shadow
The farther out the curve you go, the smaller the Fed’s influence. But it never totally disappears. That’s because what the Fed is expected to do with the funds rate has a lot to do with the determination of the yield on notes and bonds. As long as investors expect the benchmark interest rate to stay at zero for “an extended period,” as promised by the Fed, and as long as they see no risk of higher inflation from holding it there, long-term interest rates are unlikely to move higher, QE2 or no QE2.
Remember, Treasury yields rose from the inception of the Fed’s $600 billion asset purchase program in November until early February amid signs that the economy was improving. Some Fed district bank presidents, who tend to be inflation hawks, questioned the necessity and advisability of expanding the already bloated balance sheet. Soaring food and energy prices pushed the consumer price index higher. Inflation was going to be the next big worry, which led investors to anticipate a rate increase later this year, reflected in fed funds futures contracts.
Fed chief Ben S. Bernanke claimed that absent the Fed’s purchases, the backup in yields from about 2.4 percent to 3.75 percent on the 10-year note would have been greater.
Now Hear This
There’s no way to know that for sure, however, because the Fed’s intention was to shoo away other investors.
“When you announce you are going to buy a large amount of Treasuries,” Crandall said, “you are saying to every investment committee: ‘We’re going to artificially depress returns in this asset class for six months. Respond accordingly.’”
For traders and investors, that response was to buy riskier, higher-yielding assets. For the rest of us, Bernanke laid out the game plan in a Washington Post op-ed on Nov. 4, the day after the central bank officially announced QE2.
The expected decline in Treasury yields, he explained, would lower both mortgage rates, making homes more affordable (though affordability isn’t the problem for the housing market), and corporate bond rates, encouraging investment (it actually encouraged companies to issue debt). Higher stock prices would “boost consumer wealth and increase confidence,” Bernanke said, and spur spending.
Cycle of Perceptions
That might have worked if consumers hadn’t been bingeing for decades. As for his other hoped-for outcomes, housing has entered its sixth year of decline. Corporations are sitting on about $2 trillion in cash. Banks are holding $1.5 trillion in their accounts at the Fed.
At least the markets heeded the Fed’s call. Spreads between corporate bonds and risk-free Treasuries narrowed. Stocks rallied. Commodities took off.
With the onset of soft patch 2 in the first quarter, the trends in those markets reversed. Treasury yields plunged as investors sought safety at a time when Europe is struggling to contain the Greek debt crisis and China is trying to rein in lending and tame inflation. Expectations of a Fed rate increase were pared back until the second half of 2012. There were whispers about QE3.
In short, the Treasury market has gone through an entire business cycle, and all that’s changed are perceptions about the economy and the Fed. Growth has averaged 2.8 percent in the seven quarters since the recession officially ended in June 2009. A percentage point one way or the other shouldn’t be a big deal, but clearly it is.
Priced for Perfection
Currently, with 10-year yields below 3 percent, Treasuries are priced for perfection: for gloom and doom everywhere else.
“The level of rates is such that by the end of July, the numbers will look rather different and yields will go back up, and it won’t have had anything to do with the timing of QE2,” Crandall said.
It may have nothing to do with QE2, but the Fed will welcome higher yields any way it can get them as a sign the economy is on a path of stronger growth.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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