Wednesday, December 8, 2010
Since the end of August, when the Fed first began to hint that QE2 was in the works, yields on 30-yr T-bonds have jumped 95 bps, driving the price of the long bond down by almost 15%. 30-yr bond yields led the way initially—because the market figured the Fed couldn't artificially depress their prices, and QE2 would make all bonds less attractive by increasing inflation—but now 10-yr yields are up 80 bps from their August lows. Over the same period, stocks have jumped 16%. That's pretty amazing, considering that one of the main objectives of QE2 was to depress long-term bond yields in order to stimulate the economy.
The only way to understand this paradoxical development—Fed purchases of bonds have caused their price to fall, and rising bond yields seem to be improving the economic outlook—is to see it as the market's way of telling the Fed it will be making a big mistake if it forges ahead with QE2. The Fed can't depress 10-yr yields if inflation is rising and the economy is on the mend. QE2 needs to be shut down, and the sooner the better.
Why? Because it has served its real purpose, which was to drive a stake through the heart of persistent deflation fears. Bond yields had fallen to very low levels by August, signaling that the market was very concerned not only about the economy but also about the potential for deflation (see the chart below for my interpretation of the significance of different levels of 10-yr Treasury yields). If successful, QE2 would have vanquished those fears, and bond yields would rise as a result. Well, in a sense it's already happened. The Fed convinced the market that it would stop at nothing to defeat deflation, and that's all that was needed. To carry through with QE2 would be redundant and run the risk of generating too much inflation.
The Fed should pay attention to these important market signals. We don't need more QE2. The economy is doing OK, and Obama's tax deal—though far from perfect—should provide enough incentives to the private sector to result in stronger growth next year. The dollar is very weak and gold prices are very high; forward inflation expectations have risen from 2% to almost 3%; and commodities are on a tear. The Fed should begin to worry about getting too much of what it professes to want with QE2.
Posted by Scott Grannis at 8:44 AM