The bond market got excited yesterday because the minutes of the July FOMC meeting reflected strong support for another round of Quantitative Easing (QE) should the economy fail to improve. The 10-yr Treasury yields fell over 10 bps on the day in apparent anticipation of more Fed purchases of Treasuries. This type of knee-jerk reaction is bound to end in tears, however.
As the above chart of 10-yr Treasury yields shows, the bond market's enthusiasm for past episodes of quantitative easing was short-lived. The first phase of QE1 was announced Nov. 25, 2008, and it consisted of up to $100 billion in agency securities and $500 billion of MBS. In the early stages of QE1, 10-yr yields declined almost 100 bps, but only for 5-6 weeks. (I think Fed purchases were overwhelmed by the widespread fears of a global financial collapse.) By late January, when the Fed announced the purchase of more agency and MBS debt, and the expectation of the purchase of long-term Treasuries, yields had jumped back up. On March 18, 2009, the FOMC formally announced the expansion of the program to total $1.25 trillion of MBS and $300 billion of longer-term Treasuries. Despite these massive and unprecedented purchases, 10-yr Treasury yields marched steadily higher and didn't peak until the end of QE1 in late March, 2010. Yes, that's right: yields rose until the time the Fed stopped purchasing bonds.
The idea of QE2 was first floated by Bernanke in late August 2010, when 10-yr yields were around 2.65%. By the time QE 2 became official, with the FOMC announcement of Novermber 3, 2010, 10-yr yields had fallen by a about 15 bps, to 2.5%. As QE 2 was implemented over the next six months, with the Fed purchasing an additional $600 billion of Treasuries, not only did yields fail to decline, they actually rose by 100 bps.
In short, the anticipation and the reality of two major rounds of Fed purchases of MBS and Treasuries only served to depress yields temporarily. The major impact of QE1 and QE2 was to drive yields higher, even though the Fed justified its efforts by asserting that Quantitative Easing would drive yields lower, and that in turn would stimulate the economy. Furthermore, this short history of aggressive Fed intervention provides no evidence whatsoever to support the notion that the Fed has artificially depressed Treasury yields. If anything, two rounds of QE only pushed rates up.
So why did massive bond purchases not only fail to drive bond prices higher and yields lower, but produce exactly the opposite of the Fed's intended result?
The short explanation is that QE1 and QE2 pushed yields higher because they were just what the markets and the world needed. The first two rounds of quantitative easing helped address deep-seated issues that were creating a scarcity of dollar liquidity, which in turn was holding back the economy and threatening deflation. Note in the chart above how QE1 and QE2 followed periods in which core inflation fell to very low levels — a sign of a shortage of money — and the Fed was very determined to avoid the threat of deflation. The demand for money was intense, and the Fed's aggressive provision of bank reserves satisfied that demand. (Bank reserves, since they now pay interest, are functionally equivalent in the eyes of banks to 3-mo. T-bills, universally regarded as the world's safest and most liquid asset.) Quantitative easing provided much-needed liquidity to the economy and to the markets, and it was a stronger economy and the reduced risk of deflation that in turn boosted yields.
But will QE3 work the same way? 10-yr yields are down almost 150 bps since the end of QE2. Some of that decline could be due to Operation Twist (which involved the sale of short-term Treasuries and the purchase of longer-term Treasuries), but I think it's more likely that yields have declined because economic growth has slowed. However, today core inflation is not unusually low, and inflation expectations, such as the 5-yr, 5-yr forward breakeven rate embedded in TIPS and Treasury prices, have been rising for most of the past year, currently standing at 2.75%.
Conditions today are quite different from what they were leading into QE1 and QE2. The economy is weak, as before, but this time the threat of deflation is quite remote. Swap spreads are very low and credit spreads are relatively low, which suggests that the economy is not suffering from a shortage of liquidity. Although gold and commodity prices are off their highs of last year, they are still way above the levels of 10 years ago, when deflation fears first surfaced, and far above the lows of late 2008 when deflation was a again a real threat. If anything, commodity prices have risen so much more than the general price level in the past 10 years that they are probably contributing to inflation.
So if the Fed proceeds with QE3 later this year, it won't be because the economy is suffering from a shortage of liquidity, or because deflation is a real threat. It will simply be because the Fed thinks — or hopes — that additional purchases of bonds will help strengthen the economy. Long-time readers of this blog will know that I don't believe that monetary stimulus can result in stronger growth. Monetary policy can remove barriers to growth, as we have seen with QE1 and QE2, but it can't create growth out of thin air. So if we do see a QE3, then this time I think its effects will be mainly to push inflation higher. And of course, higher inflation is very likely to drive bond yields higher.
So if we do get QE3, don't expect bond yields to decline — expect them to rise.