Monday, February 7, 2011

Bond market to Fed: you've got things turned around


This chart of 5-yr Treasury yields is a companion to the Vix/S&P 500 chart in my previous post. It illustrates the market's amazing reaction to the Fed's QE2 program, which was first implemented in early November. Contrary to what the Fed thought—that QE2 purchases of Treasuries would depress interest rates and thus help stimulate the economy—the beginning of QE2 marked the exact bottom for 5-yr Treasury yields, which are center-mass for the bond purchase program. It wasn't supposed to happen that way—Fed purchases were supposed to keep rates from rising, not make them rise. And since the end of January, yields have risen almost 40 bps, as better economic news has caused investors to move forward their expectations for an end to the Fed's quantitative easing efforts, and to move forward their expectations for a beginning to an eventual Fed tightening.

So the Fed had the logic and the sequence of events wrong. QE2 didn't lower interest rates, and therefore it hasn't stimulated the economy. Moreover, QE2 so far has had little discernible impact on the money supply. This leads to the conclusion that the economy was improving on its own, well before QE2 could have had any meaningful impact. Plus, this whole episode illustrates powerfully how economic fundamentals and market forces can overwhelm the efforts of mere Fed governors.

7 comments:

Public Library said...

It reinforces the notion Central banks haven't a clue what they are doing. And further reinforces the notion they cause more harm than good.

We will discuss this after the next Fed-induced episode of financial panic and mayhem.

We are already on our way. The only food the young or the poor will buy in 5 years is fast food. However, even these prices will elevate significantly in the years to come.

Top that with some serious Health care inflation and voilĂ , we get a fat and sagging nation separated from its food supply and medical coverage.

Brilliant 'Central' planning.

brodero said...

Way way way too much focus on QE2...it is the economy that matters
and as adjunct corporate bond borrowing....as long as corporate
bond spreads compress...QE2 is playing the lounge when the real story is in the ballroom....

fmtrading said...

Thanks for the great blog Scott - much appreciated. I was wondering if you thought maybe the expected move higher in bonds from QE2 actually happened before the announcement (a 'buy the rumour'-type move) given the telegraphing of QE2 intentions well before the official confirmation of the program?

Scott Grannis said...

I'm sure there was some "buy the rumor/sell the fact" action at the beginning which helped drive yields higher. But the fact that the rise has been sustained and it continues tells me that there is something afoot in the fundamentals. Namely, the economy is improving.

Frozen in the North said...

Maybe its not done much for interest rates, but its been wonderful for stocks. In fact, Bernanke said on several occasions that his favorite mechanism for "wealth creation" was via the stock market.

Jeff said...

Scott, I have a Finance/Econ degree from the mid 80's. I'm not in the Financial world today (except for my own investing). In my research, I cannot answer a simple question: Who owns the fed and who is benefiting financially from adding over a trillion dollars to their balance sheet?

Scott Grannis said...

Re who owns the Fed: For all practical purposes the Fed is "owned" by the US government, since the Fed remits all its profits directly to the US Treasury. Those profits amounted to a record $78 billion in 2010. The Fed profits by exchanging reserves (on which it is currently paying 0.25% per year) for short- and intermediate-term Treasuries (on which it earns 2-3% per year). In short, the Fed profits from the steepness of the yield curve.