If you spend any amount of time reading or watching the mainstream media, it has likely been pounded into your brain that quantitative easing (QE) lowers interest rates. Because of this, many investors were caught off guard when rates jumped higher after the Fed announced another round of quantitative easing last week.
The fact that QE sends interest rates higher rather than lower is not a new phenomena. In fact, as popular journalist Joe Weisenthal shows us in his piece "The Biggest Mistake People are Making about the Collapse in Interest Rates," rates moved higher after both QE1 and QE2 as well.
From Joe's piece:
….the evidence shows that QE leads to higher rates.
Here's one of our favorite charts, from Jeff Gundlach that everyone needs to sear into their minds, which shows that rates increased each time the Fed did QE, and fell each time the Fed stopped QE.
So why does QE raise interest rates?
The pundits did not pull that concept that QE lowers interest rates out of thin air. Econ 101 teaches us that if a large buyer comes in and starts buying something, then without an equivalent increase in supply, the price of that something goes up. In the case of treasuries (whose price moves in the opposite direction of interest rates) higher prices means interest rates have fallen.
What is unique about this particular case is two things:
1. As the Federal Reserve buys up treasuries, they are simultaneously increasing the supply of money. More money chasing the same amount of goods and services increases the price of those goods and services. The market knows this, so when the Fed embarks on QE, inflation expectations increase, sending interest rates higher.
2. More money available to buy goods and services should also mean a pickup in the economy. As people adjust their growth expectations they pull money out of super safe assets like treasuries and put that money into riskier assets like stocks. This is why the stock and bond market normally have a negative correlation. When the stock market is going up the price of treasuries is normally falling, meaning interest rates are going up.
What's the Bottom Line?
Investors should now prepare for higher interest rates, not lower, at least until QE3 is over.