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QE Not Working Out as Planned, but Hey, I'm Just a Caveman Economist


The Fed and pundits are declaring QE victory based on employment and rising stock prices, but correlation does not mean causation.

With QE tapering now front and center on the minds of the Street's investment strategists, the analysis has now shifted from whether or not the Fed will taper to when tapering will begin, by how much, and what it could do to the market. In an effort to get ahead of this tapering event, this past week FTN's Chris Low, one of the Street's most well-respected economists, explained QE's market influence in three bullets:

The three ways QE affected rates. 1. Removed bonds from the market (flow). 2. Relationship between size of portfolio and rates (stock). 3. "Bernanke put." The three ways QE affected rates.

Now I'm really confused. His number 1 is 2 and his 3 is 1. After I read this research with the backdrop of the massacre underway in the bond market, I seriously wondered whether anyone really knows how QE works, and more importantly, how it will un-work.

The debate among academic and investor circles is broken down into a basic stock versus flow argument. Bond yields are influenced by the size of the Fed's holdings relative to outstanding supply (stock) and by the process of bidding for securities on the open market (flow).

In a 2011 paper published by the St. Louis Federal Reserve titled Flow and Stock Effects of Large-Scale Treasury Purchases that studied the impact of the QE I program, the authors break down the definition:

"Flow effects" are defined as the response of prices to the ongoing purchase operations and could reflect, on top of portfolio rebalancing activity due to the outcome of the purchases, impairments in liquidity and functioning of the Treasury market….

Meanwhile, "stock effects" are defined as persistent changes in price that result from movements along the Treasury demand curve and include the market reaction to changes in expectations about future withdraws of supply.


We find that both types of effect were statistically and economically significant. Specifically, we estimate that the average purchase operation temporarily reduced yields by about 3.5 basis points and that the program as a whole shifted the yield curve down by up to 30 basis points, with both effects concentrated at short to medium maturities.

Princeton Economist and New York Times columnist Paul Krugman agrees, writing on April 19, 2011:

I basically think of asset prices in a Tobin-type stock equilibrium framework (PDF). People make portfolio choices, allocating their wealth among bonds, stocks, etc. Asset prices – including the famous "q" – rise and fall to match these portfolio choices to the actual asset supplies.

On this view asset purchases matter because over time they change the stocks of assets available: by buying long term federal debt, the Fed takes some of that debt off the market, and hence drives up the price of what's left, reducing interest rates. The flow – the rate of purchases – matters only to the extent that it affects expected returns.

Chairman Bernanke provided support to the stock view responding to a question from MNI's Steve Beckner in the April 25, 2012 post-FOMC press conference (emphasis mine):

There's some disagreement, I think, about exactly how balance sheet actions by the Federal Reserve affect Treasury yields and other asset prices. The view that we have generally taken at the Fed in which I think–for which I think the evidence is pretty good is that it's the quantity of securities held by the Fed at a given time, rather than the new purchases, the flow of new purchases, which is the primary determinant of interest rates. And if that is -- if that theory is correct, then at such time that our purchases come to an end, there should be relatively minimal effects on interest rates at that time.

Over the past few months that theory has been completely blown to pieces. The Fed has done nothing to change the scope of the program yet the bond market is melting in their face. The Fed's balance sheet and flow of purchases both continue to increase, yet the market is completely impervious to their influence. This implies that in the bond market, which is the only thing that matters, QE has become irrelevant, which means Fed policy has become irrelevant.

With all of the truly worthless research analyzing when tapering will begin and by how much -- both of which are irrelevant -- the most important analysis that has gone unaddressed is why the idea of tapering elicited such a massive move in interest rates. Has any credible Wall Street strategist explained why this is happening? This is a critical to understanding why the QE trade is blowing up.

Without going into detail about the Fed's ex post QE cost/benefit analysis policy error, the simple answer lies in the focus of the program. When the Fed opted to target the MBS market they entered the arcane realm of interest rate volatility. Mortgage securities are short volatility by virtue of the prepay option the borrower retains, thus MBSs are much more sensitive to swings in interest rates.
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