Wednesday, July 9, 2014
With today's release of the June FOMC meeting minutes, we learn that the Fed will almost certainly finish the "tapering" of QE3 in October. As of this writing, interest rates are almost unchanged on the day, so the news was as expected. But as the chart above shows, 10-yr Treasury yields are still substantially higher than they were when QE3 began about 21 months ago, and that is not what were told to expect. The Fed has purchased over $1 trillion of Treasuries and MBS since late 2012, but Treasury and MBS yields have nevertheless risen, not fallen, and by a significant amount. So much for the quaint notion that QE purchases were designed to lower interest rates and thereby stimulate the economy.
As the chart also shows, interest rates have risen during each episode of Quantitative Easing. Even Operation Twist, which was designed specifically to reduce the yield on 10-yr Treasuries, failed to deliver on its promise, since at the end of OT yields were the same as when OT started. Yields briefly dipped, but on balance OT was a fruitless exercise in yield curve manipulation.
What we've learned from all this is that the Fed can't manipulate interest rates. Interest rates rose during each episode of QE because the effect of Quantitative Easing was to supply the world with much-sought-after safe, short-term securities. See my explanation of how this works here. By supplying much-needed, risk-free liquidity to the financial system, the Fed helped avert a liquidity squeeze that could have otherwise hurt the economy. QE restored some financial health to the markets, and that served to bolster the market's confidence in the recovery, and that in turn led to higher interest rates.
When QE1 and QE2 ended, interest rates plunged. That wasn't expected either: wouldn't the end of Fed bond purchases have ushered in an era of rising yields? It didn't work that way, because in retrospect we can see that the Fed should not have discontinued its bond purchases. The Fed exited QE prematurely, twice, at a time when the world still needed extra, risk-free liquidity. Once they resumed QE purchases, yields rose and the outlook for the economy improved.
So it's very encouraging to see that the approaching end of QE3 has not resulted in any significant decline in yields. I think this reinforces my post earlier this week (risk aversion is declining). The world is less risk averse, and so the need for safe, risk-free securities such as bank reserves has declined. Ending QE3 is not going to be a problem for the economy, like it was in 2010 and 2011. The market can handle things on its own this time, without the Fed needing to "transmogrify" bonds into T-bill equivalents. The outlook for the economy is thus a bit healthier, and that's why yields are higher today than they were in mid-2012.
So the end of QE3 is not the end of the world, it's the beginning of the economy's ability to grow on its own; the beginning of the end of risk aversion. It's good news.
Posted by Scott Grannis at 12:15 PM