Tuesday, 8 January 2013

Quantitative easing and bond yields

Last week, I wrote that global stocks rose in 2012 because of quantitative easing by central banks.

Government bonds are the direct beneficiaries of quantitative easing, but the depressed bond yields that result have forced investors to reach for return in higher-risk equities, thus pushing up prices of the latter.

The effect of quantitative easing on bond yields have actually been somewhat controversial, with some arguing that QE causes yields to rise because of raised expectations on future economic growth and inflation. For example, Matt O'Brien at The Atlantic has a chart that shows that yields “rise almost every time the Fed buys bonds, and fall almost every time it stops”.

However, in his latest blog post, Mark Dow points out that this effect of QE -- officially termed LSAP -- is only short-term.

Now, let’s go back and look at the chart again. You will see what technicians call “lower highs and lower lows”. And it’s important to note that this pattern was taking place against the backdrop of an improving economy which would normally push UST yields higher.

This to me means two important things: one, LSAPs have almost certainly over time lowered the clearing rate for UST yields—even though the impulse correlation, driven by economic expectations, has worked in the short-term in the opposite direction.

The second observation is that the “expectations effect” was of lesser amplitude with each Fed announcement, again, against the backdrop of an improving economy... This is because sentiment surrounding monetary policy has done a 180 over the past two/three years. Because the shifts in expectations were not subsequently validated by fundamentals, market participants progressively came to view effects from Fed policy as psychological and ephemeral... Most everyone by now has wrapped their head around the notion of “liquidity trap”.

Dow concludes that “the end of LSAPs will matter for yield levels”. However, he also thinks that while monetary policy has been relatively impotent so far, things may be starting to change.

Monetary policy can be very, very powerful when the soil is fertile. This is not the time to become complacent about the impotence of monetary policy. That time has passed. It may not be tomorrow, but the efficacy of monetary policy has now become, as the economists might say, a positive function of time.

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