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.

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