The Market Doesn’t Think the Fed Will Ever Sell Those Bonds Back
You know the trillion dollars a year of Treasury and GSE bonds that the Fed’s buying up? (And the $3-trillion+ it’s already holding?) It’s driving up bond prices and suppressing yields, right? And if it starts selling them back, it will drive down prices and increase yields, right?
The market should be front-running that, right? They should be driving down prices in expectation of the Fed eventually selling.
But they’re not, are they? They must not expect the Fed to ever do that. The market must think that if anything, the Fed will just let those bonds retire naturally (which will reduce the future stock of bonds held by the private sector, but not the flow to/from that sector — that already happened when the Fed “retired” the bonds onto its balance sheet).
Welcome to the brave new world where:
o Total reserve balances and the size of the Fed’s balance sheet are immaterial to interest rates or lending to the real sector.
o The policy rate is purely a function of the Fed-specified IOR (interest on reserves) floor.
o Open-market operations/QE only affect asset prices via the flow effect (with bond spreads based on what maturities the Fed’s currently buying/selling).
o Fed buying/selling pushes bond and equity prices in the same direction (because high bond prices/low bond yields push investors into equities, and vice versa).
o The Fed’s push/pull on all asset prices only affects real-economy spending via the wealth effect.
Cross-posted at Asymptosis.
The monetary base reached 22.8% of GDP in 1946Q1 compared to 17.7% during 2013Q1. There was never any need to exit from the more than six-fold increase in the monetary base that took place in 1932-48. The most that the monetary base decreased was from $48.413 billion in December 1948 to $42.960 billion in April 1950, or by 11.3%. And even that decrease probably had only minimal negative consequences because of the expected decline in real output following World War II.
“Fed buying/selling pushes bond and equity prices in the same direction (because high bond prices/low bond yields push investors into equities, and vice versa).”
You do realize that this is absolutely false, right?
By the way consider Japan. The BOJ began its current QE in early April and bond yields went up, not down.
Countervailing forces: 1. purchases pushing bond prices up, 2. expectations/optimism pushing them down.
Since the beginning of QE, purchases seems to be winning, with expectation effects being short-lived and steadily weaker.
Since the most “permanent” and aggressive announcement yet made, on Dec 12, we’re seeing no expectations effect. Or the optimism is being overwhelmed by other effects, like austerity. Choose your counterfactual.
O’Brien: “Just consider the counterfactual where there was no quantitative easing. Asset prices, like stocks and homes, would almost certainly be lower.”
Add: and bonds.
Meanwhile I’m happy to see that Michael Woodford and Adair Turner both agree with the main thrust of this post:
And the go farther, saying the CB should explicitly promise that they’ll never sell the bonds back. In which case they can just burn them. Might do wonders for expectations/optimism!
1) “Since the beginning of QE, purchases seems to be winning, with expectation effects being short-lived and steadily weaker.”
Actually the effects have been fairly consistent.
QE1 was announced on November 25, 2008 and concluded on March 31, 2010. The 10-year T-Note closed at 3.35% on November 24, 2008 and closed at 3.84% on March 31, 2010, an *increase* of 49 basis points.
QE2 was hinted at in Jackson Hole on August 27, 2010 and concluded on June 30, 2011. The 10-year T-Note closed at 2.50% on August 26, 2010 and closed at 3.18% on June 30, 2011, an *increase* of 68 basis points.
QE3 was hinted at in Jackson Hole on August 31, 2012. The 10-year T-Note closed at 1.63% on August 30, 2012 and 2.20% on June 11, 2013, an *increase* of 57 basis points.
2)” Since the most “permanent” and aggressive announcement yet made, on Dec 12, we’re seeing no expectations effect. Or the optimism is being overwhelmed by other effects, like austerity. Choose your counterfactual.
The announcement on December 12 made two changes one of which was completely expected and the other of which was previously hinted at and not of any immediate importance.
Everybody expected the FOMC to announce the purchase of T-Bonds since the Federal Reserve had essentially run out of T-Bills to trade for T-Bonds under the Maturity Extension Program (MEP).
The other was the shift to unemployment rate and inflation rate thresholds for the timing for when the fed funds target rate is raised, something which was talked about beforehand by Evans, Kocherlakota and Yellen. Given the increase in the fed funds rate was already clearly stated by the FOMC to be nearly *three* years in the future this was hardly a “permanent” or “aggressive” announcement.
3) “Add: and bonds.”
If there was no QE, the rate of growth in NGDP would be lower and consequently bonds would be higher, so bond *yields* would be even lower. The expectations effect is far more important than the liquidity effect. Even now the Fed is a relatively minor holder of Treasuries (about 15% of all outstanding) but it is still the only U.S. institution that creates base money.
P.S. The overall downward trend in the 10-year T-Note yields is mostly due to the decline in real interest rates. But the 10-year TIPS has increased from an all time low of (-0.87%) on December 6, 2012 to positive 0.13% on June 11, 2013. It closed above zero on June 7 for the first time since January 24, 2012, over 16 months ago. One interpretation of this rather quick rise in real rates is that markets expect real growth to increase.