Bond Market Rejects Fed's Unconditional Love: Caroline Baum
Dec. 20 (Bloomberg) -- Nicholas Sargen, chief investment officer at Fort Washington Investment Advisors, and Jud Pyle, a portfolio manager at PEAK6 Investments LP, talk about outlook for U.S. stocks and the Federal Reserve's policy of quantitative easing. Sargen and Pyle speak with Carol Massar, Matt Miller and Dominic Chu on Bloomberg Television's "Street Smart." (Source: Bloomberg)
How’s that QE2 working out for you?
To answer the question, we first have to establish the goals of a second round of quantitative easing as laid out by Federal Reserve Chairman Ben Bernanke. The Fed’s purchases of U.S. Treasuries “affect the economy primarily by lowering interest rates on securities of longer maturities,” Bernanke explained in a Nov. 19 speech in Frankfurt. Lower rates equate to more “accommodative financial conditions,” he said.
Oops.
Bernanke went on to say that QE is really a misnomer for what the Fed is doing. Quantitative easing works by increasing the quantity of bank reserves. Treasury purchases, on the other hand, “work by affecting the yields on the acquired securities” and forcing investors to buy higher-yielding, riskier assets, he said. Thanks for the clarification.
Based on those metrics, how is QE2 faring?
Credit spreads, or the difference between the yields on risk-free Treasuries and other debt securities, have narrowed. Check.
Stocks have rallied. Check.
As for the primary intent of QE2, which is to lower long- term interest rates, that hasn’t worked out according to plan.
Not so, say some observers, who argue that the rise in long-term rates is prima facie evidence QE2 is working, that higher rates correlate with stronger growth.
That was quick. What happened to those “long and variable lags” with which monetary policy is said to operate?
Real Story
A better, or more nuanced, interpretation of the Treasury market’s response might be that QE2 was unnecessary, with the increase in yields suggesting an improving economy independent of any renewed stimulus on the part of the Fed.
The yield on 10-year U.S. government notes set a low for the year of 2.4 percent in early October. After the Nov. 3 announcement of QE2, yields skyrocketed, reaching 3.53 percent last week before retreating to 3.33 percent yesterday. The yield on five-year notes jumped more than 1 percentage point as well.
Even worse from the Fed’s point of view is the rise in real yields, adjusted for inflation expectations: from 0.36 percent to 1.2 percent on 10-year inflation-protection securities, or TIPS. Policy makers teed up the idea that fanning inflation expectations would cause real yields to fall, providing oomph to the economy at a time when the federal funds rate is already close to zero. Instead, the lion’s share of the increase in yields since QE2 got under way has been in real rates, with inflation expectations inching higher.
Of course, the Fed can always fall back on the claim that yields would be higher without its intervention, a politically popular tactic because such assertions can’t be proved.
Yield Curve Speaks
The Fed has bought $137.5 billion of intermediate and long- term Treasuries so far of the $600 billion it intends to buy through June. That amount is not subject to changing economic conditions, Bernanke implied on a “60 Minutes” interview on Dec. 5. In fact, additional purchases are “certainly possible,” he said, stressing that, at the current pace of job growth, the unemployment rate could remain elevated for four or five years. (Yesterday, St. Louis Fed President James Bullard challenged that view, telling CNBC that QE2 was “reviewable and changeable.”)
Rising long-term rates and a steepening yield curve are expansionary, an indication that the benchmark overnight rate would be rising, too, if it were left to market forces instead of to the central bank.
A steeper yield curve is an inducement for banks to expand their balance sheets, even if it’s through purchases of U.S. government securities, not loans. (The Fed may think QE works through prices, not quantities, but some economists, including the late Nobel Laureate Milton Friedman, would beg to differ.)
Too Much Love
Part of the rise in yields may be anticipatory, which is why rates have ebbed in the past week. Still, it coincides with evidence of an improving economy, starting with the Index of Leading Economic Indicators -- nine of the 10 components registered an increase last month -- and moving on to encouraging signs from retail sales, consumer confidence, manufacturing surveys and factory output.
That’s not to say it’s smooth sailing for the U.S. economy. The nation has structural problems to address, a tax code to streamline, deficits and debt to pare and entitlement programs to reform. The short-term focus, evident in both government and the private sector, will have to give way to longer-term thinking if the U.S. is to avoid the fate of other empires.
The Fed, meanwhile, seems comfortable that the benefits of QE2 exceed the costs. Any indication the balance is shifting in favor of greater costs will send long-term rates soaring.
Even when it comes to unconditional love, there can be too much of a good thing.
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