Wednesday, December 8, 2010

QE2's days are numbered

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.


Benjamin Cole said...

Bernanke said only a couple days ago he will proceed with QE2 and more, if need be. I doubt that a possibly temporary 100 bp rise in ultra-low yields will change Bernanke's mind. He is a very serious student of both Japan and the Gret Depression, I get the impression Bernanke know of what he speaks.
The Nipponistas are calling for the Fed to ape the Bank of Japan, but Bernanke knows where that leads--oblivion for investors the economy and America's role in the world.
Anyway, if you think rates are low now, hold on--they may o even lower. As the global economy recovers, huge pil;es of cash will build up (already are). Sheesh, American corporations are sitting on hoards of cash, banks are holding hoards of cash, private funds are sitting on cash, sovereign funds are fat etc etc ete.
There isn't enough places to invest all of it. Hence, even lower yields ahead.
The US Treasury is oversubscribed at every auction.

brodero said...

The amount of cash to equities is still enormous. There are 2.810
trillion dollars sitting in money
market assets. The Wilshire 5000
( showing my age) is 12.944 trillion. The ratio is 21.7%. Look at this (dated() chart

We are very far away from being
overvalued on a cash to assets ratio.

Benjamin Cole said...


But what about cash in corporate coffers, private equity funds, hedge funds, sovereign nation funds and in banks?

It seems to me that new forms of holding cash have grown since the 1980s and the heydays of money market funds.

Public Library said...

I think you are grossly underestimating Bernake's intentions Scott.

Inflation is baked into his DNA and his track record for reading market tea leaves is abysmal. Don't count on Bernake reading the same market signals as you. The FEd's history is littered with examples of boom/bust enabling with the belief in clean-up efforts err I mean printing more money to validate their services.

Scott Grannis said...

Public: you make a valid point, but I would counter with the fact that Bernanke is already facing a lot of discord among the FOMC. An almost unprecedented level of discord. What is playing out in the market these days is only going to add fuel to the opposition's fire. He is playing with a very volatile and unstable situation. I dont think this can go on much longer.