Fed Purchases And U.S. Yields: It's All About Foreign Investors

by: Evariste Lefeuvre

Wednesday's Fed Minutes might provide us with some more information regarding how Fed members gauged the impact of the shutdown on the economy as well as the possible opposition regarding the timing and implementation of the tapering and forward guidance. It will not give more details on the genuine impact of the non-conventional monetary measures have had on financial markets.

I have shown several times that the link between equity market returns and the size of the Fed's balance sheet was far from straightforward (here). Even in periods where data series seem correlated, the interpretation seemed quite difficult: in late 2011 for instance, the S&P 500 posted negative returns while the Fed was expanding its monetary base. In mid-2012, the Fed actually reduced its purchases while stock returns remained positive.

Interestingly enough, the link with US Treasury 10-year yields is even more puzzling. As can be seen below, the 6-month change in US Treasury yields was not only loosely but also oddly (in the economic term) linked to the size of the Fed's balance sheet: more purchases would mean higher yields.

There are several explanations to this. In particular, for many market participants, the Fed was actually targeting risky asset prices. As their correlation with UST yields was negative, it explains why yields rose when the Fed was expanding its purchases.

This view though, would tend to be slightly at odds with the widely accepted view among FOMC members that the size, not the flow of purchases has an actual impact on US yields.

The chart below shows the breakdown of Treasuries holders by types. It shows that even if the total outstanding of debt held by the Fed has increased, that of Foreign holders have followed the same pace. Of course, as the second chart on the right suggests, it could be that many foreign countries have stockpiled US Treasury debt in the midst of the financial crisis (safe haven flows).

Yet, as can be seen the ratio of foreign holdings to Fed holdings has stabilized since 2011 (the stability of the financial sector / Fed ratio would suggest that the Fed did not substitute for this sector in financing US deficit during that period).


This would suggest that the Fed played a marginal role in containing changes in US Treasury yields, especially since the purchases of US Treasury bonds by Foreign investors has been above that of the Fed throughout the post Great Recession era (the exception being mid-2011).

Maybe the most interesting pattern is presented in the chart below. It shows two very important things:

1. The current account deficit of the US economy is improving through a mix of better fiscal (im)balance and better exports (oil related but not only).

2. Above all, its financing has completely changed over time. In the run up to the financial crisis, foreign purchases of Treasury bonds financed a small portion of the current account deficit. This is clearly understandable given the most of the external deficit was driven by an excess leverage of the private sector. What is alluring though is that since 2009, the external account has improved but Treasury purchases by foreigners more than finance the external accounts of the United States (barring the recent tapering fear).

Click to enlarge

Bottom line: The Fed may have some problems to assess properly the impact of its action on the US GDP (see here), the impact of the non-conventional policy on financial markets is not straightforward either.

As I have shown, the link between US Stock performance and Fed purchases is not clear. But the most troubling feature of the last few years is that the Fed did not substitute for foreign investors in the purchase of US Treasury bonds. Instead of being overly afraid of the Fed may be the focus should switch to the ability of foreign investors to finance the US deficit at a time when global exports growth is stalling.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.