Friday, December 23, 2016

The Fed doesn't control bond yields

For years I've been saying that the Fed can't control bond yields, but the myth that the Fed can manipulate yields (e.g., by buying lots of 10-yr Treasuries and/or by buying lots of MBS) persists. Experience tells us that the Fed can only control short-term rates, and even then it is questionable whether the Fed can move rates up or down by more than the market is ready for at any given time. Recall the bond market tantrum earlier this year when the Fed hinted that it might raise rates several times during the course of the year, and the Fed then quickly backed off, raising rates only once (recently). Bond yields are effectively set by market forces, and are heavily influenced by the market's perception of the future of Fed policy, the expected level of inflation, and the outlook for economic growth.

Here are some charts which compare the history of the Fed's purchases of Treasuries and MBS and their corresponding yields. You can judge for yourself whether the Fed has managed to manipulate those yields with its Quantitative Easing programs.

The chart above shows what happened to 10-yr Treasury yields during the Fed's three Quantitative Easing programs. In each period, despite massive bond purchases, the yield on 10-yr Treasuries rose. Ironically, the Fed justified QE by saying it would depress yields, and that in turn would stimulate the economy. What I think really happened to cause yields to rise despite Fed bond purchases was that the Fed's QE efforts supplied badly-needed bank reserves to the system, and that satisfied the market's thirst for safe assets; that in turn resulted in healthier market liquidity, which in turn caused the market to become somewhat more optimistic about future growth, which in turn caused the market to anticipate higher short-term interest rate guidance from the Fed in the future.

The chart above compares the magnitude of the Fed's Treasury purchases with the level of 10-yr yields. It stands to reason that the Fed could potentially manipulate the bond market only if it buys or sells a quantity of bonds that is significant relative to the outstanding supply of those bonds. Thus the rationale for the blue line, which is the ratio of the Fed's holdings of Treasuries relative to the total marketable supply of Treasuries. Several things jump out: 1) during 2008, as Fed holdings of Treasuries were plunging, yields were falling, and 2) in 2013, as Fed holdings of Treasuries was surging as part of QE3, Treasury yields surged (both in contrast to what the Fed promised QE would do), and 3) the Fed currently holds about 18% of outstanding Treasury debt, and that is about the same amount it held at the end of 2004 and less than the 20% of Treasury debt it held at the end of 2002, yet yields today are much lower than they were back then. Tough to see any convincing or enduring correlation between these lines.

The chart above compares the magnitude of the Fed's MBS purchases with the level of MBS yields. Here we see that despite huge MBS purchases in 2009, MBS yields were relatively unchanged. More recently, with Fed holdings of MBS holding relatively steady, yields have surged. No convincing causality or correlation that I can see between these two lines.

The recent surge in bond yields has almost nothing to do with Fed policy, and very little to do with increased inflation expectations. It's mostly about an improving outlook for growth assuming that Trump is able to reduce the tax and regulatory burdens that have been holding back growth for the past decade.


Alain said...

Merry Christmas Scott from Canada. Thanks for all of your great posts.

Would love an update on credit swaps grap, box vs 10 year , and other liquidity graps. The regular liquidity and markets r healthy update.

Sometime in the new year.

steve said...

100% agreement. I'm not even convinced we need a fed.

Benjamin Cole said...

As usual, great post.

Maybe 2017 will be a good year and I hope so. Trump is promoting optimism, and discussion about business, rather than foreign entanglements. All good.

I am worried about rate hikes by the Fed. Property values are already wavering in Hong Kong, several other nations linked to US dollar.

If property values stagnate in the US, then look for slowdown.

New money enters the US economy largely through real estate. About 80% or commercial bank lending is on real estate. The term "commercial banks" has become a misnomer. Think "Property-Lending Commercial Banks."

When banks lend money to buy real estate, they essentially print money (see endogenous money supply).

There used to be an argument the Fed controls the money supply. And maybe it does, sort of. But with $2 trillion in reserves, the banks can lend it they want to. They are not going to, if real estate stagnates. The Fed can cut to zero, and it won't help.

The Fed appears loath to go back to QE, or even consider "money-financed fiscal programs" aka helicopter drops. I believe QE worked not on interest rates, but as the ultimate bond sellers had to do something with the cash they received. So they spent it, or invested in other assets.

Normally, when a bond-seller sells a bond, another private buyer buys it, and that second private buyer has to give up consumption or making another investment. But when the Fed buys a bond, no one has to give up anything. It was a way for cash to enter the economy, but not through the real-estate lending channel.

At any rate, keep an eye on real estate.

BTW, the economic fates of people living along the West Coast is more in their own hands than Obama's or Trump's.

If Orange County CA would go to free markets, and eliminate all property zoning, there would be a 20-year boom there in real-estate and business development. Why, Scott Grannis would be dragooned out his house, slapped into overhauls and hard hat, given a hammer and told to start pounding.

Unzoning property should be the cause celebre of 2017!

ronrasch said...

Merry Christmas to you Scott and all God's blessings to you throughout the New Year

bob wright said...


What does "OT" stand for in your first graph?


WealthMony said...

"OT" = Operation Twist

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