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The Effects of QE on Treasury Yields -- Now the Answers Start to Matter

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Why neither side of the quantitative easing debate has it entirely right.

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Not so fast. Look more closely at the chart.

The idea behind large scale asset purchases, of course, is that they are supposed to drive down interest rates and facilitate the healing of bloated private sector balance sheets, in our case, in the household and financial sectors. This, in turn, would lead ultimately to a resumption of lending, once the lenders and borrowers have worked themselves back into stronger financial positions.

The theoretical debate has taken for granted that LSAPs lower rates, and instead focused on the channel through which the purchases would achieve this. Thinking about these channels is important.

First, there is the "Flow" channel. Some academics and most markets participants have been inclined to believe that LSAPs lower rates through a flow effect - that is, through the physical purchases. The intuition here is powerful: Sharply increased demand means higher prices, and lower yields.

On the other hand, many academics and policymakers - including the bulk of the Fed - believe rates are lowered through a stock effect. That is, asset purchases reduce the available stock of assets, and so, for a given view, the clearing price will be higher (and the yield lower) than otherwise would have been the case. The implication is that this affects, over time, the level of yields, even if the oscillations in yields are driven by other factors, such as economic expectations.

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. In fact, after QE3, there was virtually no bump at all. 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. It went from "very hard" two years ago to make the case that QE wouldn't be inflationary to "fairly easy" today. Most everyone by now has wrapped their head around the notion of the "liquidity trap."

Two conclusions can be drawn from this. One, the end of LSAPs will matter for yield levels - even if the Fed decides not to sell any of its holdings and let its book run off. So, if you think it is entirely about economic expectations, you are likely to underestimate the magnitude of yield "normalization."

Two, many investors and analysts have settled into the notion that we are in a liquidity trap, and that monetary policy here is largely "pushing on a string." While this is still for the most part the current environment, it is finally, slowly, 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.

This article originally appeared on Behavioral Macro.

Twitter: @mark_dow
No positions in stocks mentioned.
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