Tuesday, March 29, 2011
The end of QE and what it means for the market
How QE works.
Whenever Quantitative Easing is mentioned in the media we hear a lot of commentary about “pumping money in” or “injecting liquidity.” Critics decry the money printing by the central bank, etc.
It’s all wrong.
I’m telling you this not that you’ll ever get into one of these discussions with your friends (you may) or even if you did, whether you’d be able to convince them of the fallacies of these arguments, but sometimes it’s just fun to know stuff.
A lesson in QE.
The term quantitative easing applies to a policy whereby the central bank, in this case the Fed, purchases assets (usually government securities) to expand the level of reserves in the banking system and, where desired, target a lower interest rate somewhere along the yield curve.
In the recent QE that was announced last summer, the Fed desired to bring down the interest rate on bonds and so it bought 5yr and 10yr Treasuries.
These Treasury purchases are done in the secondary market with the Fed buying from the public. The Fed doesn’t buy from the Treasury (it’s often misstated as that being the case). In fact, the Fed is precluded by statute from buying bonds directly from the Treasury.
When the Fed buys the bonds it “pays” by crediting the seller’s bank with reserves. Bond purchases (or any asset purchase) results in an addition of reserves to the banking system. Bond prices rise as a result of the Fed’s purchases and yields (which move inversely to bond prices) come down or, at least that’s the intent.
Is the Fed injecting “liquidity?”
No. There is no “liquidity” being injected anywhere.
That’s because all that’s occurred is an asset swap—a Treasury for a reserve balance. Both are exactly the same thing in that they are dollar denominated liabilities of the Federal Government, the only difference being their term and the interest rate they pay: Treasuries have some term, i.e. 2yr, 5yr, 10yr, etc while reserves are zero maturity. Both pay interest, but at different rates.
Therefore, when the Fed conducts QE, it strips the public of one asset—a Treasury—and replaces it with another—a reserve balance. No new money is created.
Is this hyperinflationary or even inflationary?
You can clearly see that it is not. It does not create any “new money” as, say, government spending would. All it does is change the shape of the yield curve, i.e. change the net duration of the financial assets held by the public.
Why did commodity prices run up, then? And why did the dollar tumble?
Perception, pure and simple. There is a belief that QE equates to the Fed “printing money.” Investors and traders act on that belief and push up the prices of commodities and they sell the dollar.
Why didn’t the Fed’s plan result in lower bond yields?
Part of the reason is because QE was widely perceived as being stimulative and a lot of economists started ratcheting up their economic growth forecasts. Bond yields rose on those forecasts.
Another reason why QE did not bring yields down is because the Fed decided to limit the program to a specific QUANTITY of bonds rather than target a specific rate itself. In other words, if the Fed wanted the 10yr to be at 2.0%, say, it should have stated that target and buy as many bonds as necessary to hit the target and then maintain it. This is how it sets the Fed funds target. Instead, the Fed said it would buy $600 bln, without knowing whether or not that would be sufficient to get to its desired rate.
(Now you know how to set rates, in case anyone asks you to run the Fed one day. ;))
What happens now that QE is ending?
Operationally, the Fed will stop buying bonds and crediting the banking system with reserves. Rates may move higher because the Fed will not be in there buying, however, to the extent that market participants feel “stimulus” is being removed, bond yields may actually come down. And since QE adds nothing to economic demand, the end of QE takes nothing away, either.
Furthermore, if investors feel that the removal of QE will result in less “inflationary pressure” from the central bank, commodities, gold and oil may come down and the dollar may go up. If so, all this will do is change the composition of the market’s leadership.