On Wednesday, the U.S. Federal Reserve announced that they would be adding the outright purchase of U.S. Treasuries to their latest quantitative easing program (QE3) that was first launched in mid-September. Under this program, the Fed intends to purchase $45 billion in Treasuries each month going forward until the state of the U.S. economy improves to their satisfaction. Such a program would presumably be most positive for the Treasury market, as one should reasonably expect that it will shift out the demand curve for U.S. government bonds and thus, drive prices up and yields down. And this is certainly an oft-heard investment theme among analysts and media talking heads. But history has repeatedly shown that since the beginning of the financial crisis, the exact opposite is true. In short, U.S. Treasuries tend to struggle mightily under QE.
A focus on long-term U.S. Treasuries as measured by the iShares 20+ Year U.S. Treasury Bond (TLT) gets directly to this point. Under both QE1 and QE2, the U.S. Treasury market immediately began to sell off from the moment the Fed revealed its intent to purchase these securities. And in both cases, this selling continued for months before finally stabilizing. During QE1, long-term U.S. Treasuries declined by -15% over the first three months of the program before going on to finish the program in March 2010 still down -11%. As for QE2, U.S. Treasuries sold off by -16% in the first several months before steadying in early February, and still ended -10% lower at the conclusion of the program in June 2011.
The recent reaction by the Treasury market to QE3 suggests we are likely to see more of the same in the coming months. When the Fed first announced QE3 back in mid-September, long-term U.S. Treasuries immediately sold off by -4%. And from the moment the Fed announced its latest purchase program on Wednesday, long-term U.S. Treasuries fell off a cliff, dropping by -1.2% in a matter of minutes and grinding lower through the remainder of the trading day.
What explains this counterintuitive reaction by U.S. Treasuries? Why is it that when the Fed shows up as a major buyer of Treasuries that the market almost immediately recoils to the downside? This is due to the signal that the Fed sends to the market and the flood of liquidity that comes along with it. In short, the Fed's purchase of Treasury securities encourages participants in the market to take on more risk, and the actual Treasury purchases injects a steady stream of additional capital into the financial system that helps make this happen. The net result is that more money ends up rushing out of the Treasury market to pursue higher returns opportunities than enters in through the Fed's purchase program.
The following example helps highlight this point. When QE2 was revealed to the markets back in 2010, the total market capitalization of the U.S. stock market was $15.0 trillion. And by the time the program ended in mid-2011, this same reading was $17.9 trillion. This marks a $2.9 trillion increase in the capitalization of the stock market at a time when the Fed purchased $600 billion in U.S. Treasuries. While certainly not all of the increase in U.S. stock market cap (or various commodities prices for that matter) can be exclusively attributed to the movement of capital out of Treasuries, the fact that the Treasury market sold off during this time period suggests that the outflows from investors into risk assets were exceeding the inflows from the Fed.
So how is the U.S. Treasury market setting up today as QE3 is getting up to speed? Watching price performance between now and the end of the year will be particularly critical. At present, long-term U.S. Treasuries continue to enjoy support at several key levels despite the latest breach of the 50-day moving average (blue line on chart) with Wednesday's close at $122.59 on the TLT. The first key support level is the upward sloping trend line that has been in place for much of 2012 and currently rests in the $122.50 range on the TLT. The second is the 200-day moving average (red line on chart), which is currently at $121.20 on the TLT. And the third is a support level at $120.00 on the TLT that has been in place since May 2012. A decisive break below these key support levels, particularly the 200-day moving average, would indicate that the U.S. Treasury market has fully engaged another QE-induced corrective phase that may last several months before stabilizing.
But with any such corrections come opportunity. The long-term U.S. Treasury market has been one of my most favored investment themes since the very beginning of the financial crisis. This is due to the fact that it not only provides a safer way to short the U.S. stock market when the need presents itself, but it also has performed tremendously well during periods when the Fed is not engaged in balance sheet expanding QE monetary stimulus programs (see the unshaded areas in the chart at toward the beginning of the article).
And given that this latest QE program does little to solve the underlying fundamental problems that continue to hinder the global economy -- it can be argued that in many respects, QE is actually compounding these problems -- and is unlikely to result in sustainable growth just like its predecessors, the long-term trend in U.S. Treasury yields appears likely to continue to the downside. Given that 30-Year Japanese Government Bonds are currently yielding 1.93% and 30-Year German Bunds are yielding 2.25%, it is certainly not beyond the realm of possibility to see the 30-Year U.S. Treasury yields meaningfully lower from its current 2.91% reading before it's all said and done, despite the fact that the direction is likely higher in the near-term due to the Fed's latest QE program.
So while I do not currently own a position in TLT, I will be watching closely in the coming months for potential reentry points once any initial QE euphoria in risk assets begins to moderate. In the meantime, for those interested in maintaining a hedge against a declining stock market for portfolio protection purposes, Build America Bonds (BAB) with a rolling 3-year returns correlation to the stock of -0.55 provide a lower beta alternative to the TLT, along with a better ability to continue moving to the upside during periods when the stock market is rising as it is likely to do with QE3 picking up speed as we enter the New Year.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.