Wednesday, July 9, 2014

QE3 to end in October, but the world doesn't

With today's release of the June FOMC meeting minutes, we learn that the Fed will almost certainly finish the "tapering" of QE3 in October. As of this writing, interest rates are almost unchanged on the day, so the news was as expected. But as the chart above shows, 10-yr Treasury yields are still substantially higher than they were when QE3 began about 21 months ago, and that is not what were told to expect. The Fed has purchased over $1 trillion of Treasuries and MBS since late 2012, but Treasury and MBS yields have nevertheless risen, not fallen, and by a significant amount. So much for the quaint notion that QE purchases were designed to lower interest rates and thereby stimulate the economy.

As the chart also shows, interest rates have risen during each episode of Quantitative Easing. Even Operation Twist, which was designed specifically to reduce the yield on 10-yr Treasuries, failed to deliver on its promise, since at the end of OT yields were the same as when OT started. Yields briefly dipped, but on balance OT was a fruitless exercise in yield curve manipulation.

What we've learned from all this is that the Fed can't manipulate interest rates. Interest rates rose during each episode of QE because the effect of Quantitative Easing was to supply the world with much-sought-after safe, short-term securities. See my explanation of how this works here. By supplying much-needed, risk-free liquidity to the financial system, the Fed helped avert a liquidity squeeze that could have otherwise hurt the economy. QE restored some financial health to the markets, and that served to bolster the market's confidence in the recovery, and that in turn led to higher interest rates.

When QE1 and QE2 ended, interest rates plunged. That wasn't expected either: wouldn't the end of Fed bond purchases have ushered in an era of rising yields? It didn't work that way, because in retrospect we can see that the Fed should not have discontinued its bond purchases. The Fed exited QE prematurely, twice, at a time when the world still needed extra, risk-free liquidity. Once they resumed QE purchases, yields rose and the outlook for the economy improved.

So it's very encouraging to see that the approaching end of QE3 has not resulted in any significant decline in yields. I think this reinforces my post earlier this week (risk aversion is declining). The world is less risk averse, and so the need for safe, risk-free securities such as bank reserves has declined. Ending QE3 is not going to be a problem for the economy, like it was in 2010 and 2011. The market can handle things on its own this time, without the Fed needing to "transmogrify" bonds into T-bill equivalents. The outlook for the economy is thus a bit healthier, and that's why yields are higher today than they were in mid-2012.

So the end of QE3 is not the end of the world, it's the beginning of the economy's ability to grow on its own; the beginning of the end of risk aversion. It's good news.


Benjamin Cohen said...

Well, I can die and go to heaven now. Scott Grannis has conceded that the Fed quit QE early.
Is it too early yet?
The record in Japan suggests QE should be thought of in long-terms, or even as conventional Fed policy.
John Cochrane suggests converting entire federal debt into bank reserves. The Dallas Fed just put outvstudy saying QE fights inflation.
I think the idea of very large and permanent Fed balance sheets has come. There is an erroneous sentiment that somehow a large Fed balance sheet is a burden---but on who? The Fed prints money. It is no burden on tax payers, that is for sure.
In ZLB-land, QE is conventional policy. And given long-term trends in interest rates, we may see a lot of ZLB in our future.

Charles said...

QE is the equivalent of reducing sea level by filling buckets. It had no effect on the economy and stopping it will have no effect on the economy.

The Roller said...

Business is booming, making tax receipts to career politicians strong. Leading to less bonds available. Which in turn leads to less Fed bond buying! Yew!

William said...

Scott - Over the past 3 years, your analysis of QE has been brilliant and spot on. I have not read an article in the WSJ or on Bloomberg that explains the effects of QE as clearly as you have.

In addition, I am not aware that the any Federal Reserve governors has explained their actions as clearly and logically as you have.


Scott Grannis said...

Thanks. I'm amazed no one else has picked up on this way of seeing QE.

Benjamin Cohen said...

Add on:

Well, Scott Grannis is a great economist and has a good story to tell on QE, but I wonder about parts of it.

Why would someone in a very liquid and very safe US Treasury bond sell just to be in a barely slightly more liquid but slightly less secure bank deposit?

There is some interest-rate risk in being in US Treasury--but remember, it is as liquid as a "sell" button on a computer keyboard. Very active market.

But also remember in the 2008 IndyMac bank collapse depositors actually lost money, if they had more on deposit than was covered by FDIC insurance. Even with the sale of Indymac to IMB Management Holdings, an estimated 10,000 uninsured depositors of Indymac lost of over $270 million.

So there is credit risk in being in a bank deposit. No one ever lost money in a Treasury bond.

Scott Grannis points out that US commercial bank reserves swelled by about the same amount as the Fed's QE program. So, he suggests Treasury bond sellers just dumped the cash into banks, and banks sat on it.

But there may be another scenario.

Both the Mideast and Far East were and are troubled places through the same time frame. Investors in China, Hong Kong and Taiwan, and in the Mideast (oil), may be moving cash into US banks, even as US households also built up cash deposits.

In this second scenario, cash deposits at US banks swelled due to greater savings by US households, and global flight capital.

In contrast, the Fed's injections of QE money was either re-invested in other assets or spent.

Of course there could be a combination of what Scott Grannis thinks happened and what I suspect happened. I do not think the data is out there to clarify this.

For sure, we have globalized capital markets, and any explanation of what happens has to take into account what investors worldwide will do.

Such luminaries as John Taylor, Milton Friedman, Ben Bernanke and even Alan Meltzer (!) have been proponents of QE.

So to say QE has "no effect" I think struggles against some very serious thinkers.

As stated, my concern is that the Fed, as it has for the last 30 years (along with the ECB and BoJ) is "fighting inflation."

It is very difficult for a central banker to say "I am fighting for robust growth."

I think they would choke on the words.

steve said...


I'm certainly no fan of QE which I view as manipulation BUT the markets have become intoxicated with all things FED so no QE and indeed a reversal will be a psychological blow.

Charles said...

Steve, a secondary effect of QE is to confuse the financial markets. You have a relatively large player, who may be large enough to affect prices, acting irrationally. What happens when the elephant leaves the room? The fact that the markets are not reacting to the taper is a sign that they have concluded that nothing will happen.

At the psychological level some people are still wedded to obsolete notion that QE is money printing and that the economy is affected when the fed fiddles with the money supply. In truth money is endogenous and the process of financial intermediation creates all the money the economy needs - absent a crisis in the banking system. The crisis was over long ago.

Looking at the big picture, global liquid assets are in the tens of trillions of dollars. How can the monthly conversion of $100 B from one liquid asset to another have any effect at all if the program is announced to the world at the start?

steve said...

charles, I totally agree. but if the effect is not psychological and not effectual, why do it in the first place. QE was "real" to the extent that it forced lots of $ into risk assets. therefore, it's reversal, which admittedly will probably take a long time to come to fruition should be expected to cause the reverse response.

Benjamin Cohen said...

Dep't of Beating a Dead Horse--

Okay, I have a question.

Scott Grannis says there has been a tremendous demand for cash since 2008, met by QE. Bank reserves swelled.

But at the same time, since 2009 there have been huge run-ups in global stock markets (especially the US) and in global property values.

Investors (since 2009-10) have not been running from equities and property, they have been running into them!

Add on, since 2010 gold has dumped!

This suggests to me investors do like what they see in the real world, and they are buying.

Of course, you could have schizophrenia in investors. Some are fearful, going into gold and cash, while others boost equities and property.

But on balance, how does fear explain swelling bank reserves, if global equity and property markets are booming?

This suggests the swell in US commercial bank reserves (and it would be nice to know what happened in other nations) was caused by household savings and political flight capital from Mideast and Far East.