Monday, May 9, 2011

Why the end of QE2 is good news

What is likely to happen when the Fed's QE2 program is finished next month? Here are two competing theories and possible scenarios (for related discussion see today's WSJ article on the subject):

Weaker growth, lower Treasury yields. QE2 was a successful program, providing needed stimulus to the economy and vanquishing deflation fears. That is why 10-yr Treasury yields started rising as soon as the program started in early November. The end of QE2 therefore will hurt the economy by withdrawing needed stimulus; a weaker economy, in turn, will increase the demand for safe-haven Treasuries, driving yields lower. This explains the recent decline in 10-yr Treasury yields, since the market is already pricing in the expectation of a weaker economy, disregarding stronger economy news such as the greater-than-expected increase in April jobs.

Stronger growth, higher Treasury yields. QE2 never provided direct stimulus to the economy, since it never resulted in any meaningful addition to the amount of money in the economy. And since the end of QE2 will not result in the withdrawal of any of the bank reserve injections, nor shrink the Fed's balance sheet, it should have no direct effect on the economy. QE2 was indirectly helpful, however, since it effectively vanquished deflation fears and this helped boost investor confidence. That helps explain why equities started rising shortly after the idea of QE2 was first floated in late August, and the subsequent rise in Treasury yields was the market's natural reaction to news that the economy was indeed improving. To the extent that QE2 increased the market's uncertainty about the outlook for inflation and weakened the dollar, however, it was a drag on the recovery, which has been modest by historical standards. Treasury yields are relatively low today because the market is ignoring signs of strength (e.g., faster jobs growth) and worrying instead about possible threats to growth in the future, some of which likely have been exacerbated by QE2 (e.g., higher oil prices, weaker dollar).

My sympathies lie with the second scenario, because I don't believe that Washington has the ability to create or fine-tune growth through standard Keynesian measures. Fiscal "stimulus" which relies on more government spending and transfer payments can never create growth, since it destroys incentives and makes the economy less efficient, and stimulative monetary policy can only create inflation (i.e., you can't print your way to prosperity).

The above chart is my way of interpreting the significance of different levels of 10-yr Treasury yields. I've never believed that Fed purchases of Treasuries were artificially suppressing yields. Instead, yields are driven mainly by inflation and growth fundamentals. Growth expectations feed into inflation expectations, since both the market and the Fed believe in the Phillips Curve theory of inflation, which holds that very weak growth is potentially deflationary, while very strong growth in potentially inflationary. Today's yields are symptomatic of a market that expects very weak growth.

This next chart shows a decent correlation between 10-yr Treasury yields and the year over year change in the core CPI. With core and headline inflation rates now trending upwards (the 6-mo. annualized change in the core CPI is 1.4%, and the headline CPI is 4.7%), we have likely seen the lows in Treasury yields. Yields are only as low as they are today because the market is very concerned that the economy is at risk from a cessation of QE2, from high oil prices, from a renewed bout of housing weakness, and from the fiscal austerity measures that will be necessary to deal with our out-of-control federal budget.

The market is ignoring signs of rising inflation and rising prices because it believes that they will eventually be trumped by very weak growth. This assumption, however, is likely to be put to the test by the end of this year, since I believe that we will see the economy tending to grow a bit faster and inflation tending to increase.

Meanwhile, the end of QE2 won't change the Fed's balance sheet, but it will mean we no longer have to worry about the Fed compounding any inflationary errors that it may have been making with QE2. And if the Fed ends QE2 because it is worried about the dollar and rising inflation and not overly concerned about the economy's supposed weakness, then that should bolster confidence and strengthen the dollar, and that in turn should be an impetus to growth. Likewise, if Congress manages to put in place policies that lead to a reduction in the size of our bloated government, that is likely to boost confidence and increase economic efficiency over time, thus leading to stronger growth.

In short, instead of worrying about the end of monetary "stimulus" and fiscal "stimulus," we should be cheering. Misguided stimulus is bad; ending it is therefore good. The economy is struggling under the weight of too much "stimulus," and it needs a break.


dh said...

Ballsy call saying the treasury mkt is out to lunch. Fair enough, but ballsy.

Scott Grannis said...

Markets are smart, but at times they can be wrong, very wrong. It will be interesting to see if I'm right.

Vespasianus said...

Scott, latest cover of The Economist (line chart of a "crash" photoshopped onto Miss Liberty's tablet) wondering what's wrong with America's economy, should fire up all our contrarian instincts, in my humble opinion.


K T Cat said...

Thanks for posting these charts and your analysis. The only thing I'd add is that standard analysis works until it doesn't. Witness Greece. At some point the sheer volume of outstanding debt becomes the dominant factor and then all the conventional models collapse as investors flee from an insolvent debtor.

Up until the last 6 months (12?), Greece could have been said to have been following a standard model for interest rates and unemployments and other economic measures. Now all of that is gone and the place is in ruins.

My problem with the end of QEII is not interest rates but volume. Just who is going to buy $100B of Treasuries every single month? Every month is going to be a rollercoaster with ups and downs driven by random world events. The volume of the debt will make the system unstable and investors panicky.

This was a balance sheet recession and borrowing monstrous amounts of money never helps your balance sheet. I don't think this one is over yet.

K T Cat said...

A link and a response.

Anonymous said...

This was a great article Mr. G., that,, I believe goes straight to the core of the problem that the US is facing, the fiscal one, especially under S&P's negative watch, they just don't have a choice, lose your AAA status, and this is Armaggedon (as Cramer would say)...looks like this stimulus put a band-aid, but did not solve anything, quite to the contrary....but I bet you, somehow, S&P will, over the next year, lose a lot of credibility, in the markets...they always find a way out...

Scott Grannis said...

KTC: There is a huge difference between Greece (and the other PIGS) and the US: we can print dollars to pay our debt, but they cannot. They can become insolvent, we cannot.

AdamSmith said...

There may be a legitimate third scenario. About 90% of T bonds at auction were bought by the fed over past months at low yields. When QE2 ends, who will want to buy low yielding bonds denominated in a weak and falling currency? Not the Chinese, Japanese or Euros. Not Pimco. Why not a buyers' strike forcing higher yields?

Scott Grannis said...

I would argue that the price of T-notes and T-bonds is determined by the market's willingness to hold the outstanding stock of fixed income securities, which is much, much larger than the new issuance of those securities and the Fed's QE2 purchases. Fed purchases on the margin do not determine the value of Treasuries or the value of all outstanding bonds (which are all priced relative to Treasuries), which add up to several tens of trillions of dollars.

Benjamin Cole said...


Over and over again, we are hearing about exports boosting US growth. That 1Q growth was 1.4 percent, and that increased exports accounted for 1 percent of that. In other words, without export growth, we are nearly dead in the water, in the !Q.

We also hear (and I think truthfully) that exports have been boosted by a lower exchange rate for the dollar.

If QE2 lowered the exchange rate for the dollar, then did not that help GDP growth through increased exports?

As for interest rates, it seems clear today that capital markets are global. That means interest rates are set by global demand and supply for capital.

Global supplies of capital are vast and growing. I suspect with a global economic recovery, we are entering a great age, in which the shortage will not be capital, but great ideas into which to pour capital.

This should depress interest rates for a long, long time. Just finding a place to park your money--US Treasuries--may become difficult. Yields will be very low, perhaps below inflation rates.

acrossthecurve said...

K T Cat-

There may be a point where can't handle 100 billion a week/month or whatever. I don't see that as a concern today or even this year. There just isn't alot of places to park 100-250 billion. China, Saudi Arabia, Calpers, Pimco(bill gross will be back) will all be major buyers of treasuries should they start to decline near 4%. Long-term could be a different story but as long as we get deficits down and work to pay down some debt we should be able to avoid that disaster.


great post, I couldnt agree more that any govt stimulus(intervention) is bad for the economy.

K T Cat said...

"KTC: There is a huge difference between Greece (and the other PIGS) and the US: we can print dollars to pay our debt, but they cannot. They can become insolvent, we cannot."

Just think about what you've said. Like the slowly boiled frog, we've reached the point where we're printing $100B a month to cover our debts and we still think things are fine. It's breathtaking.

As for the Chinese buying our debt, if they wanted to do so, why aren't they? The other big buyers have been the Japanese. With 200% GDP in debt, are you suggesting they're going to keep buying? Isn't it more likely that they will be large-scale net sellers in the near future?

AdamSmith said...

Scott, large sovereign and private holders of Treasury debt won't pound it out because it would implode the value of their holdings. They are hostages. However, they can lay off their US Treasury exposure by entering into long term hard asset supply contracts in USD - which is what China is doing at a frantic pace. In the meantime, they are not buying more Treasuries.

Benjamin Cole said...

FanCan, KT Cat, AdamSmith-

There is a global capital glut. The question is not whether the USA can sell bonds, but whether investors have anywhere to park their capital.

That said, I concur the USA needs to get back to balanced federal budgets. However, a stimulative monetary policy is also a good choice.

TradingStrategyLetter - Weekly Summary said...

QE II was obviously a main factor in the last 2 years for solid corporate and market growth.

I can't wrap my head around no QE II 'still being' good if it is taken away.