It is a claim that you will hear often in the financial news about quantitative easing (QE). And it often comes from the most respected and highly regarded experts in the investment world. Even the Fed Chairman himself often cites it as a primary motivation for engaging in new balance sheet expanding monetary stimulus programs. What is the claim? That QE is a program that leads to lower interest rates. In fact, the exact opposite is true.
An examination of interest rate movements since the beginning of the financial crisis highlights how QE actually causes interest rates to rise, not fall. Conversely, when the Fed is not engaged in balance sheet expanding monetary stimulus, interest rates fall, not rise.
Above is a chart of the 10-Year U.S. Treasury yield from September 2008 to the present. Highlighted are the three balance sheet expanding monetary policy programs by the two major global central banks in the U.S. Federal Reserve (Fed) and the European Central Bank (ECB).
Upon the outbreak of the financial crisis following the collapse of Lehman Brothers, yields plunged sharply as investors fled to the safety of U.S. Treasuries. And although they bounced from what was then a long-term bottom in mid December 2008, they remained relatively low through March 2009. It was then that the Fed fully engaged in what is now known as QE1. And from March 2009 to March 2010, 10-Year U.S. Treasury yields steadily rose from 2.7% to 4.0% at the very end of QE1. Thus, QE1 caused the yield on the 10-Year U.S. Treasury to rise by roughly 130 basis points.
From the moment that QE1 concluded at the end of March 2010, interest rates immediately started to fall. And through October 2010 right before the launch of QE2, 10-Year U.S. Treasury yields had dropped from 4.0 % all of the way back to 2.4%, a decline of roughly 160 basis points.
Once QE2 was launched in mid November 2010, interest rates began to march upward once again. Over the course of three short months through February 2011, 10-Year U.S. Treasury yields spiked higher from 2.4% to 3.7%, a rise of roughly 130 basis points. From there, interest rates stabilized and eventually rolled back over through the end of QE2, although they still finished roughly 80 basis points higher on the 10-year Treasury at 3.2%.
Again, from the moment QE2 ended, interest rates quickly moved back down. Over just 46 trading days, 10-Year U.S. Treasury yields plunged lower, breaking below 2% for the first time in the post crisis period by early September 2011. By the launch of the Fed's Operation Twist at the beginning of October 2011, 10-Year Treasury yields had fallen by roughly 140 basis points to 1.8%.
The most recent balance sheet expanding monetary stimulus program came courtesy of the ECB, which launched its Long-Term Refinancing Operation (LTRO) in late December 2011. Once again, from the moment this program was launched until just after its conclusion in February 2012, 10-Year U.S. Treasury yields jumped from 1.8% to 2.4%, a rise of roughly 60 basis points in a little over two months.
Since the end of the ECB's LTRO, interest rates once again began moving lower. By early June 2012, 10-Year Treasury yields had fallen below 1.5%, a decline of roughly 90 basis points.
After staying lower through the end of July 2012, interest rates started to rise again. Not at all coincidentally, this shift directly coincided with Draghi's proclamation of doing "whatever it takes" on July 26 and the Fed changing its language about potentially applying further QE from "may" to "will" following its August 1 meeting. Since that time, we have seen 10-Year U.S. Treasury yields rise roughly 50 basis points from 1.4% to 1.9%, including a 20 basis point jump since QE3 was launched last week.
Given such concise and repeated evidence that balance sheet expanding monetary stimulus actually causes interest rates to rise, not fall, it stands to reason why the Fed is not pressed more sternly on the validity of its claim to the otherwise. Also, the fact that interest rates actually fall, not rise, when the Fed is not applying QE also raises the question of why the benefits on interest rates associated with NOT applying more QE are not more fully recognized and evaluated. Moreover, why so many experts, including those at the Fed, continue to promote the claim that QE will lower interest rates and benefit bond prices, including Treasuries, when the exact opposite has proven true is curious, to say the least.
So why exactly are we seeing the opposite occur for interest rates from what so many expect? A variety of explanations can be provided, but the most reasonable is that the Fed is not the only buyer of Treasuries and other securities in the market place. Instead, it is the actions of market participants in response to the Fed's actions or non-actions that result in an outcome that is the converse of what is expected. Thus, in the case of the fixed income market, it seems that you can clearly fight the Fed.
For example, when the Fed is not applying QE, investors will migrate to the relative safety of U.S. Treasuries for protection against a slowing global economy and the threat of crisis from places like Europe. This safe haven demand from investors more than offsets the loss of buying power by the Fed once QE ends. On the other hand, once the Fed opts to launch a QE program, this signals to investors that it is safer to take on more risk. This notion is supported by the fact that financial institutions receive an injection of daily liquidity from the Fed as a result of their regularly scheduled asset purchases, as at least a portion of this liquidity leaks its way into risk assets steadily along the way, as evidenced by the euphoric daily stock market melt ups that often occur under QE programs. As a result, investors will sell out of safe haven Treasuries and back into risk assets such as stocks (SPY) and commodities during QE. And this investor migration out of safe haven Treasuries and back into risk markets more than offsets the increased demand provided by Fed purchases under such programs.
Thus, it should not only be a surprise, but should also be expected that U.S. Treasury yields are likely to rise higher, perhaps sharply, now that QE3 has been launched by the Federal Reserve. This may be particularly true since QE3 only involves the purchase of Mortgage Backed Securities (MBS), although Treasuries will still be acquired by the Fed as a part of Operation Twist that will continue through the remainder of the year.
Looking ahead from an investment perspective, none of this means that the U.S. Treasury market or other fixed income categories should be abandoned now that the Fed is engaged in an open-ended QE program. To the contrary, it is likely to set up a potentially attractive trading opportunity, particularly on the longer-end of the U.S. Treasury curve in segments represented by the iShares Barclays 7-10 Year U.S. Treasury Bond (IEF), iShares Barclays 10-20 Year U.S. Treasury Bond (TLH) and iShares Barclays 20+ Year U.S. Treasury Bond (TLT) ETFs.
The chart above focuses on the last time the Fed engaged in balance sheet expanding QE. Yields initially spiked sharply higher upon the launch of QE2 in November 2010, but quickly started to level out a month later, by mid December 2010. And after creeping higher to their February 2011 peaks, they rallied sharply through the end of QE2 in June 2011.
Applying this pattern to the current market, it would not be surprising to see yields once again spike initially higher as investors move out of safe haven Treasuries into risk assets. But if the marketplace begins to sense that sustainable growth and endlessly rising stock prices are not likely to result from this latest QE3 experiment, the safe haven appeal of owning Treasuries is likely to return. This may be particularly true in the coming months, given the persistent and widespread risks that continue to overhang investment markets, such as ongoing threat of crisis in Europe, the mounting instability in the Middle East and the looming fiscal cliff in the U.S. at the end of the year.
Thus, watching for an opportunity to move swiftly back into Treasuries in the coming months may prove a worthwhile strategy. The only caveat would be the threat of a sustained inflationary outbreak. The primary risk the Fed has engaged with its latest program is that commodity inflation pressures could start to spiral out of control, which would present a whole new set of problems, not only for interest rates, but all investment categories. These will be important developments to monitor in the months ahead.
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
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.