How QE Alters Bond Yields (Or Rather How It Does Not)

September 30th, 2013

by Franz Lischka

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There is a general perception in the market about QE: With billions of dollars the Fed has suppressed bond yields for almost the last 5 years. Without that, yields would be much higher. Problem is: That doesn't really fit with the evidence of bond market moves around the start and ending dates of the QE-programs. Actually US Treasuries virtually crashed in early 2009 at the start of QE1, with long-term yields rising around 200 basis points. Similar at the start of QE2 in late 2010, when yields rose more than 100 basis points. Yields reversed sharply after the programs ended in March 2010 and June 2011. Only during the last programs (Operation Twist, the MBS purchases "QE3" and the Treasury purchases "QE4") the market showed little reaction, but yields jumped after the Fed began discussing "tapering" in May of this year. Only now the market seemed to be "rational". Why is that?

Well, this simple view that the Fed suppresses yields through its bond buying seems logical at first glance. But it is just too simple. It is as if the Fed was a giant bond or hedge fund that buys bonds because they seem to be good value. This view assumes that the Fed is a marginal buyer and everyone else keeps his views and positions basically unchanged.

But that is not the case. Once the Fed announced the start of QE 1 and 2, expectations changed dramatically and therefore the way people invested in the bond market.

Now assume you are a manager of a fixed income fund (or maybe you actually are). When would you buy long-term bonds? You buy when you think they are a good investment (or in these days a better investment than just keeping cash). When is a 10 year Treasury bond a good (or relatively better) investment? You always have to assume you have money and want the best investment. Whether it is a good one in this yield environment is a different question, but one that doesn't matter for this case as you have few other options. The bond is a good investment when you earn a higher yield than what you would earn in the money market (or expect to earn) over the next 10 years. Now the short end of the yield curve is determined by the Fed, the long end -- in theory -- by the market.

There is an assumption that the bond market punishes bad politics and that "bond vigilantes" will dump US Treasuries if they think the Fed or the US government is pursuing unsustainable policies. Well, that may be true for some emerging markets, but not for the US. You can't get away from the US Dollar, as it is the reserve currency of the world. People have to hold it. This "bond vigilantes" talk is rubbish. In reality, the bond market will find its equilibrium at a level that is the average of the expected Fed Funds rate over the lifetime of the bond, plus some term premium for the duration risk that you take. I know, many people think the Fed has vastly distorted the term premium, but I think that is negligible. The 10 year Treasury is basically the sum of the expected future Fed policy. The US yield curve can be hedged or traded in any slice. You can buy forwards of the yield for example between 6 and 7 years from now and so forth. So if somewhere along the yield curve the price differs from the expected yield as in the example in 6 years' time, there would be arbitrage opportunities.

So to sum it up: The short end of the yield curve is set by the Fed, and the long end is merely the average of the expected path of the yield the Fed will charge over the given time.

So what happens when the Fed announces a QE program, especially when it announced the first two? Remember that at that time there was a big deflation scare. The Fed Fund rate had been at zero since 2008 and the world feared the US would become another Japan. Fed Funds might stay at zero for an infinite time. In this environment bond yields reflected this danger and yields were rock-bottom. Then the Fed announced QE. What was the result of the Fed basically saying "We will inflate the economy and shoot it out of deflation"? Well, first the Fed bought bonds. But did that push up their price? No, just the opposite. It changed the expectation of the market. Suddenly the likelihood of deflation had diminished substantially.

This is a chart of the inflation expectations priced into 10-year US inflation indexed bonds ("Tips"):

Please note how the first QE program, and to a lesser degree the second, increased the inflation expectations substantially and how the end of the programs brought them down again. Please also note that the current tapering talk also decreased inflation expectations (although the bond market sold off. I will come to that back soon.)

So what happened with QE1 and QE2? The Fed bought bonds, but everyone assumed that this action meant inflation would rise and that meant the zero interest policy ("ZIRP") might end sooner than was expected before QE. So the expected path of the future Fed Funds shifted upward and thereby the yield on the bonds. While the Fed bought, everyone else sold, knowing someone would be in the market to buy at any price and thereby making the whole investment less attractive than it was before. In other words QE1 and 2 didn't suppress interest rates as you hear all the time. Just the opposite occurred.

But what happened with the money? Receiving no value in Treasuries anymore, the money went somewhere else -- into more risky assets like corporate bonds, especially high yield, emerging market debt, commodities or equities.

So the basic line is this: QE did not suppress government yields, it suppressed spreads. It didn't inflate bond prices, it inflated equity prices. It meant nothing for the bond market directly, but everything for risky assets.

Interesting might be an international comparison, especially to Europe. The ECB didn't conduct any QE program, the ECB balance sheet is even shrinking lately. Nevertheless yields in Germany are now much less than in the US, although the Euro crisis is abating. Why? Because the ECB is in no position to increase rates anytime soon, given the high unemployment rate in Europe. (ECB President Mario Draghi even promised low rates for a long time.) On the other hand equity prices in Europe have gone nowhere in the last 5 years, while they are at all-time-highs in the US. (And if you think: Yes, but German stocks are on an all-time: Think again. The commonly used German DAX index is a poor comparison, as it is the only major stock index in the world that is calculated on an absolute return basis, i.e. including dividends. If you want to see the real picture, look at the DAX Kursindex, Bloomberg ticker: DAXK, that is calculated without dividends, just like everywhere else in the world. That will tell you a different story, especially if you look since 1999.)

So with QE1 + 2, bonds actually crashed, but what happened lately? Why did bonds lose money just when the Fed said it would end QE? Should bonds not gain in this case as before at the end of the other programs?

The whole connection shifted once the Fed, while contemplating new QE programs in 2012, talked about raising rates not before the unemployment rate would fall below 6.5% and at the same time hinted that QE would end when the unemployment rate would be at about 7%. Suddenly there was a connection between QE and the first increase in rates. The deflation scare had already gone and the market was used to the QE programs and expected QE (or Operation Twist, which had a similar effect, though it didn't change the Fed's balance sheet) to be kept more or less indefinitely. Any program was expected to be followed by another one. There was no surprise any more. Actually since the start of twist in October 2011, there has now been a constant bond buying program in place for 2 years in a row now, keeping the markets at constant life support. Now, different from the end of QE 1+2, the end of QE was being seen as a first step to the end of ZIRP. Any talk about ending QE was seen as getting closer to the first interest hike. It was not the expected tapering that led to the sharp increase in yields, it was the shifting path of the expected Fed's interested policy. The following chart is a comparison of the expected Fed Funds rate at the end of April, before the "tapering" talk and Sep.17th, the day before the last FOMC meeting. While the first rate hike (the cross of the line with the 0.5% mark, the most likely level after the first hike) was once expected to be in 2016, it was now in early 2015.

But what was actually the big deal that really changed at the last FOMC meeting? While almost everyone focused on the postponement of the taper and attributed it to the falling bond yields in the days after to that decision, the real deal was the remarks from Bernanke that the Fed may raise rates only after the unemployment rate would fall substantially below 6.5% -- a possible hint that the Fed may move away from the 6.5% mark. That shifted the expected Fed Funds Rate out to the right, meaning any hike would be delayed as well. Although some Fed presidents after the FOMC meeting hinted that the taper might start at the next meeting and the bounce the stock market experienced right after the meeting soon evaporated, the shift in interest rates stayed its course in the following days.

So what does that all mean for the future? For that I would have to make some guesses.

My assumption is that the Fed will end its QE programs by around the middle of next year, just as it had planned. With unemployment rates falling and initial claims now near the lows of the last decades the arguments in favor of QE are getting weaker. The question is, of course, why did the Fed not taper? My guess is that it was because of the looming government shut down and possible debt ceiling crises. The Fed didn't want to hit the brakes just when things might become a bit crazy in Washington. Remember that the last debt ceiling crises in July 2011 led to the sharpest drop in stock prices since the Financial Crisis. That happened just as the Fed had ended QE2. So having that in mind, the Fed might have wanted to wait and see how it all plays out. The economic data would be a bad excuse. They were not really worse than in spring when the taper talk began.

So I guess the Fed will move on as originally planned, just with a short delay, once the debt ceiling fight is resolved. But at the same time they may shift the 6.5% level for the first hike or attach it with some other rule like an inflation floor, as St. Louis Fed President James Bullard proposed. That would mean QE will end, but any rate hike would be postponed.

Given that QE directly means nothing for the bond market, but everything for the equity market, I would expect next year to be bad for stocks, but good for bonds. Especially since any correction in the stock market and probably in the commodities market as well may lead to a flight-to-safety and falling inflation expectations, as happened at the end of QE 1+2 , thereby shifting any rate hike expectations to the future.

Now I am not a long-term bond bull. Given the falling labor participation rate, which I regard as mainly demographic driven (through the retirement wave of the baby boomers, meaning this will be a long-term trend for the next 10 years), I expect the unemployment rate to fall further in the coming years to a level that will at some time lead to inflation and will force the Fed to act. And to be honest, bonds don't really offer any great risk-return level, even at these increased levels. Nevertheless, the current steepness of the yield curve, which is near historical highs, means that much is already priced in. Just by holding the bonds, you earn through the "rolling-down-the-yield-curve" effect.

In conclusion, I assume that in 2014, despite the end of QE, bonds will have a surprisingly good year (though it may be their last one).


Franz Lischka works as an asset manager in Vienna, Austria. You can visit his blog at http://franzlischka.blogspot.com

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