It is a common belief among investors that quantitative easing by the Federal Reserve is supportive of the US Treasury market, and that it leads to lower yields and higher prices. On the surface, such a conclusion is certainly rational. After all, if the Fed is spending billions of dollars buying US Treasuries, this additional demand should support prices even further. But history has repeatedly shown since the beginning of the financial crisis that the exact opposite is true. US Treasuries do not rally under QE. Instead, they suffer mightily.
Nowhere is this phenomenon more pronounced than the long-term area of the US Treasury market. A look back over the last five years clearly demonstrates this point. It was in March 2009 that the Fed expanded its still-developing QE program at the time to include Treasury purchases. Over the next year through March 2010, 30-Year US Treasury yields ballooned by over 1.25 percentage points, peaking on the very last day of the program in March 2011. When QE2 was revealed to the market later that year in August 2011, 30-Year US Treasury yields once again jumped by 1.25 percentage points over the next several months. And in recent months, we’ve seen 30-Year US Treasury yields rise by 70 basis points once expectations for QE3 began to build in the summer of 2012, including 40 basis points since it was officially announced back in mid-September.
If US Treasuries perform so poorly when the Fed is actively engaged in QE, what happens when the Fed steps away? They perform tremendously well. From the moment that QE1 ended, US Treasuries rallied sharply with the 30-Year recovering all of its losses in the five months from April to August 2010. And 30-Year yields dropped a whopping 1.50 percentage points in the first three months after the end of QE2 from July to September 2011.
So what is the explanation behind this paradox? Why do Treasuries struggle when the Fed starts buying and rally when the Fed steps away? The answer lies in the fact that all else is not being held equal when the Fed decides to act. In short, when the Fed begins purchasing Treasuries, it encourages increased risk-taking with the net result being that more money ends up rushing out of the Treasury market to pursue higher-return opportunities than enters in through the Fed's purchase program. On the flip side, when the Fed steps away from Treasury purchases, this discourages risk-taking with more investor money flocking to the safety of the Treasury market than is being lost by the Fed ending its program.
These forces are not limited exclusively to the Fed and QE, for if another major global central bank engages in asset purchases on a massive scale, the same effects can also apply. Such was the case from December 2011 to February 2012 during the European Central Bank’s (ECB) Long-Term Refinancing Operation (LTRO).
The 20+ Year US Treasury Bond iShares ETF
(NYSEARCA:TLT) highlights this paradox even further. Since the outbreak of the financial crisis, the time to purchase the TLT has been when the Fed is at the later stages if not the end of a QE stimulus program. And the time to sell the TLT has been when the Fed is about to begin a new round of QE. Thus, I exited all TLT positions back in September 2012 and it has come as no surprise to see the TLT break to the downside below its 200-day moving average in recent days, as this move has coincided almost to the day to the launch of the Fed’s outright Treasury purchases on January 3 as part of its current QE3 program. For as we have seen under past rounds of QE, the TLT can remain locked in a downtrend below its 200-day moving average for most if not all of a QE program.
Looking ahead, continuing to monitor the TLT for any signs of a bottoming pattern for renewed consideration remains worthwhile, as it still represents one of the best ways to protect against crisis and effectively short the stock market. But in the meantime, it remains best to step aside and reallocate elsewhere.
No positions in stocks mentioned.