Treasury Yields and the Fed's QE2 Intervention

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Let's review Treasury yields since the Fed's November 3rd press release announcing the strategy popularly known as QE2:

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.
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Because the press release was published at 2:15 EST, I've set the review start date for the following day. The first chart overlays two yield-curve snapshots: November 4th and the most recent market day, November 19th.

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The curve has steepened over the past 10 trading sessions, with disproportionately greater yield increases in the middle of the curve.

The next chart shows how dramatic the increases have been for such a short period of time, especially during the first six sessions. As of November 15th, the 2-year had increased by 60.6%, the 3-year by 80%, and the 50-year by 45.2%. Over the past week the yield changes have been mixed, with the 5- and 7-year increasing slightly, the 2-, 3-, 10- and 30-year declining a bit. The 3-month oscillated higher but finished the week flat.

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It's too soon to draw any firm conclusions about the effectiveness of the new round of Fed Treasury purchases. Part of the problem is the potential conflict between promoting economic recovery and tweaking core inflation. Consider:

  • If the strategy is to increase the spread, then the early results are positive, especially for the middle maturities.

  • If the strategy is to reduce rates across the board to stimulate the economy, the early results are disturbing. In fact, the dramatic increase in the 3-year yield over the timeframe in our snapshot is unprecedented in the 3-year Treasury data back to 1962.

QE2 is a gambit. At face value, we must assume that speeding the recovery and increasing core inflation to the target rate are the true motives. The Fed says as much, and the concern of the sole dissenter, Thomas Hoenig about long-term inflation risks, reinforces this view. On the other hand, blog commentators have speculated on a range of ulterior prime motives — ranging from bank bailouts to funding Uncle Sam with interest-free loans, etc.

We are in the early days of an innovative Fed program initially planned to extend through Q2 of 2011, but with regular reviews and adjustments. Much could change, not least of which is the behavior of foreign purchasers of Treasuries: significant cuts in future purchases would be a game-changer.

Treasury yields will merit close attention for the foreseeable future.

Disclosure: No position