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O. Young Kwon
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O. Young Kwon, NYU Ph.D. in Economics had worked in securities industry for ten years as a Registered Investment Adviser. He taught Macroeconomics and Statistics. Prior to his academic career, he was an Economist/Bank Supervisor at the Bank of Korea (the Fed's counterpart). In 2009 he set up the... More
  • QE2 and Yields: The End of QE2 May Affect Yields But Be Short-Lived 0 comments
    Jul 9, 2011 10:59 AM

    The second round of quantitative easing or QE2 ended. Most investors have different ideas and views on what really is going to happen after QE2 because we have read so many conflicted articles and have seen so many persuasive talks.

     

    The mathematical analysis in macroeconomics – compiling data, modeling, testing, charting, and forecasting – has greatly contributed to financial markets and monetary policy until the unprecedented 2007 financial turmoil, but it has shown its unwelcome drawbacks after that. To remedy some shortcomings of macroeconomics as a dismal science, consulting the basic theoretical concepts rather than leaning too heavily on quantitative analysis is one of the right ways to pursue.

     

    The Fed has sailed on the uncharted sea to counter the global recession which was not only much deeper and severer than the previous ones, but also was much complex because of  its international scope, its synchronized character, and its credit-driven crisis as opposed to the previous simple slowdowns of business activity with the healthier financial system. In the previous recessions, the financial sector led recoveries, but in the current recession and recovery process, however, the financial sector has been in the center of problems, and has kept dragging the economy down with the housing and labor markets until now.

     

    The Fed’s innovative and treacherous maneuvers including two rounds of EQ have been launched to stimulate the economy. QEs provided the endless topics about their timing, effectiveness, and side-effects. Some discussions proved short-sighted, or based on shaky logical grounds.  As we witnessed, lots of articles and comments have been posted on SA. Based on my comments last six months about the QE2-realted articles, my views are consolidated, emphasizing theoretical points rather than technical aspects.  

     

    The Primary Market vs. the Secondary Market

     

    QE2 is the Fed’s Treasury buying program. The Treasury market is the largest and most-efficient market in the world where the marketable Treasury securities are more than five trillion dollars. There are two conceptually distinguishable markets: one is the primary market where the Treasury Department auctions new Treasuries and redeems matured Treasuries. The secondary market is trading Treasuries prior to their maturities. The Fed, major central banks, primary dealers, Treasury mutual funds, Treasury hedge funds, and individual investors participate in the Treasury market.

     

    Shifts of Curves vs. Movements Along Curves

     

    In the primary market, supply curve is vertical because the volume of Treasuries to auction is fixed at a point that the Treasury Department needs to raise, regardless prices (or inversely, yields). There is ordinary demand curve, sloping downward to the right. In the secondary market, on the other hand, there are ordinary supply and demand curves, sloping upward and downward, respectively, to the right.

     

    If the Fed is out of the primary market, the demand curve shifts to the left which means that the prices are lower than before, given the supplied Treasuries. As a result, after the end of QE2, prices tend to decline or conversely, yields tend to rise.

     

    In the secondary market, however, the effect is not conclusive thanks to a new policy tool -- permanent open market operations (POMOs) --, which is authorized to the New York Fed by the Federal Open Market Committee. For simplicity, suppose that the volume of new Treasuries, say $100 billion a month, is equal to the proceeds of matured Treasuries and Mortgage-Backed Securities. Since there is no shift in the demand curve, an excess demand is created, given reduced prices in the primary market. A new equilibrium price which is the same as the original price is reached gradually by moving upward along the supply and demand curves due to fierce interactions of all market participants.

     

    The Flow Concept vs. the Stock Concept

     

    It is likely that the Fed’s matured securities are less than new Treasuries if the debt ceiling is not resolved properly. In that case the demand curve may shift a bit to the left in the secondary market, and a new equilibrium price ends up at a bit lower than the original price. Note that matured securities, new Treasuries, and deficit are flows while debt is a stock. If any undesirable yield hike (inversely, price down) due to a mismatch between matured securities and new Treasuries, the Fed conducts other policy tools to pull the spiked yield down.

     

    Flow Adjustments vs. Stock (or Portfolio) Adjustments

     

     Flow adjustments are instant while stock (or portfolio) adjustments take a time. As a result, in the short run (perhaps three to nine months), portfolio adjustments for all market participants with their portfolios makes any instant disequilibrium to approach toward the original yield because a tiny flow amount (e.g., $100 billion) is ignorable compared to a huge stock volume (more than $5 trillion).   

     

    The End of QE2 Means the Fed is Only Away from the Primary Market, and the Fed continues to Stay in the Secondary Market with POMOs.

     

    Therefore, the End of QE2 May Affect Yields. If Yields are affected in the Primary Market, the Yields are Adjusted toward to the original yields in the Secondary Market.

     

    In the short run, portfolio adjustments minimize any instant disarray in yields caused by a mismatch between matured Securities (TNs and MBSs) and new Treasuries.

     

    There are many contributors to post their articles about the effect of QE’s ending. Unfortunately we have found many conflicted views. The spectrum of views is quite extensive: From one end of a no-effect-at-all view to the opposite end of a market-crash view. Who is right and who is wrong? Both ends are right and wrong. The answer is the timeframe. All others are anywhere between these two ends, but majority views are skewed to the pessimistic end. My view is inclined to the optimistic end.

     

    Timeframe    

     

    As shown in the process of yield adjustments, timeframes – at an instant or in the short run – play a crucial role. At an instant, a market-crash view might be right, but in the short run it is wrong. Because an instant negative impact at the first hour, for instance, cannot prevail over, say, three months, with the same vigor.  A no-effect-at-all view might be right in the short run while it is too extreme in an immediate (e.g., within the first hour) term.

     

    In the investment world, a success and a failure largely depends on a right strategy on a right time frame chosen correctly. In a long run (perhaps five years or longer), we simply do not know how all macro-variables – business cycles, inflation, or interest rates -- will turn out to be. Therefore, most investors focus on investing in the short run.


    The Correlation Fallacy and the Four Ballparks

     

    Some articles show faulty analyses and misguided conclusions. The problems can be pinpointed to two main sources: One is the Correlation Fallacy and the other is the Four Ballparks.

     

    The Correlation Fallacy  

     

    There are a few articles based on correlations among selected variables without a proven causation between them. A correlation doesn’t necessarily lead to any causality between them.

     

    • Correlation Fallacy One: If A and B has the highest correlation, then A affects B most.

     

    Even if A (i.e. QE) and B (i.e. yields) have the highest correlation among correlations between A and B, and A and others (e.g., inflation expectations, economic recovery, supply disruptions, or natural disasters), it does not necessarily lead to a causation from A to B unless the causality has been proven by a rigorous statistical test. Possibly both A and B would move simultaneously by the influence from any combination of others.

     

    • Correlation Fallacy Two: If A and B doesn’t have any close correlation, then A would not affect B.

     

    If A (i.e. QE) and B (i.e., the growth rate of the inflation-adjusted GDP) loosed their close correlation, then A didn’t improve B. Simply we don’t know whether A helped B or not.  Possibly A actually helped B, but possibly some negative effects of third events (in particular, inflation) did offset the positive effect of A.

     

    • Correlation Fallacy Three: If A and B are correlated, and B and C are also correlated, then A affects C.

     

    If A (i.e., QE) and B (e.g., the dollar value) are correlated, and B (the dollar value) and C (a change in commodity prices) are also correlated, then A (QE) affects C (commodity prices). QE cannot affect commodity prices directly, but QE may do indirectly through a change in money supply and interest rates (or yields). The interest-rate differential affects the exchange rate between the U.S. and a trade partner, for instance, Canada. The effect of a change in exchange rates to commodity prices cannot be easily measured.

     

     

    The Four Ballparks

     

    There are two distinguishable fields in economic theory: Macroeconomics and Microeconomics. Macroeconomics aggregates several yields of different maturities of Treasuries into a single yield – the yield (or inversely the price) – like other variables such as the interest rate, the CPI, or the GDP. Microeconomics, on the other hand, deals with all different yields of all different maturities separately. A yield curve is important in microeconomics but it doesn’t exist in macroeconomics.

     

    The combinations of A (Macroeconomics), I (Microeconomics), P (the Primary Market), and S (the Secondary Market) make four conceptual ballparks: The AP Park, the AS Park, the IP Park, and the IS Park. The Fed participates in the Treasury market as a policy maker who has no profit motive. Rewards are the motive of all others, including major central banks, primary dealers, mutual funds, hedge funds, and individuals.

     

    The Fed plays principally both in the AP Park and in the AS Park. The main activity of QE is in the AP where the Fed buys Treasuries and keeps them to maturities. POMOs are the Fed’s daily routine activity in the AS. Major central banks, primary dealers, and individuals join in these parks. Mutual funds and hedging funds, however, are mostly out of these parks because they not only trade Treasuries but also do maturity swaps within their portfolios. Therefore the macroeconomic markets (AP and AS) is relatively stable. As a result:

     

    The impact of QE’s end would be LESS SEVERE than expected because most active players are OUT at MACRO-markets (AP Park and AS Park)..  .

     

    In the IP and IS, major players are Treasury mutual funds and Treasury hedge funds. The Fed, other central banks, and individuals also join in these markets, but they would not to be active because most of them are holders to maturities. Portfolio managements of the active players and their acute competition in these markets actually work as a disequilibrium-correcting factor, in other word, as a stabilizer, in the short run. Therefore:

     

    The impact of QE’s end would be MORE MODERATE than expected because most active players are IN at MICRO-markets (IP Park and IS Park).

     

    The integration of the Timeframe and the Four Parks

     

    The right assessment of postQE2 effects can be made only by selecting both the right timeframe and the right ballparks. Otherwise discussions are faulty or conclusions are misguided or both.    

     

     

    Watching the Treasury market is much more important than analyzing the equity market. The Treasury market has been shadowed for many investors by daily ups and downs of the equity market. The true is the main determinant forces always come from the Treasury market, and QE played a vital role in this market. The Fed’s new journey without EQ2 started at July 1st. Investors simply do not know the future trajectory of the Fed policy so that the uncertainty keeps mounting. In the fiscal side, the situation is not better. This summer is going to be stormy but the weather hopefully will be cozy in September. Quantitative tightening is expected to be our next hot discussion topics in 2013 after election.

     



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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