Is QE2 A Big Bust?
No inflation, but no rate reduction either.
December 23, 2010
It’s early days yet to judge the success of the U.S. Federal Reserve’s policy reach of quantitative easing. That approach means buying up Treasuries – boosting the price and lowering the yield – to encourage investors to go out further on the risk spectrum, e.g., to corporate bonds, while making business loans and mortgages more affordable.
So far, James Hamilton at Econbrowser reports, the opposite has happened. Yields on 10-year Treasury notes have widened. Is that the result of an implementation mistake?
“[T]he mechanism by which QE2 could potentially have an effect on interest rates is by changing the maturity composition of the outstanding supplies of Treasury securities held by the public. In my research with UCSD Ph.D. candidate Cynthia Wu, we found evidence that changes in the maturity composition have historically been associated with changes in the slope of the yield curve, and that policies like QE2 had the potential to lower long-term rates even when the overnight rate was stuck near zero. The particular policy that we looked at was what would happen if the Fed tried to buy up as much debt as it could at the longest end of the maturity structure (that is, greater than 10 years). We estimated that $400 billion in such purchases might lead to a 13-basis-point drop in the 10-year yield.
“QE2 as it’s actually being implemented by the Fed turns out to be something a little different. The Fed is buying very little in the way of bonds of 10 years or longer maturity, and is concentrating its purchases instead on securities between 2-1/2 and 10 years.”
So the Fed (or in reality the Treasury Department) is actually increasing the supply of longer-term debt, which should, effectively, increase long-term interest rates.
So the model would have you think. On the other hand, the spread between 10-year notes and 30-year bonds has flattened, Bloomberg reports. That is thought to presage a reversal of interest rate cuts.
“A peak in the yield spread between 10s and 30s signals the end of an easing cycle,” said Steven Wieting, managing director of economic and market analysis at Citigroup Inc. “It’s part of a recovery and improved growth expectations. If the outlook is for a stronger recovery, then QE would be limited and they may not expand beyond it.”
Still, the Fed has little control over longer-term rates. And indeed, even buying at the short end of the curve has cost it money, according to a Reuters report. Already it has lost 3% as the yield on five-year Treasuries has increased.
On the other hand, Reuters notes, the Fed does make money: $47.4 billion in 2009.
This isn’t the first time Fed policy yielded mixed results. Remember the bond market slaughter of 1994? Financial Times columnist Jonathan Davies does.
“[T]the initial trigger was a modest 0.25% rise in US interest rates, settled on at the February 4th meeting of the Federal Reserve’s Open Market Committee. Alan Greenspan’s view was that a modest precautionary hike in short term interest rates would be sufficient to head off inflationary expectations as the US economy continued its recovery from the earlier recession. He reasoned that while a 0.5% interest rate rise might be unnecessarily unsettling, a smaller increase would help to bring long term interest rates down as the bond markets absorbed this prudent restatement of the Fed’s anti-inflationary credentials.
“The market fallout was very different, however, and an early warning that in the fast-moving deregulated global markets which had gradually been developing since the 1980s, reactions to central bank signals could be both more dramatic and sudden than policymakers now realised. In response to Greenspan’s move, instead of rising, bond prices at the long end of the yield curve tumbled, which in turn led to wholesale dumping of bonds in Europe and the Far East, imposing hefty losses on scores of highly leveraged market participants who were positioned the wrong way.”
Wrong-way Corrigans, or stubborn market irrationality/exuberance? The devils will take the hindsight and sort it out.