America went to the polls the day before the Fed announced a second round of quantitative easing, dubbed QEII. Over the subsequant two weeks, the bond market has been in retreat as fixed income investors have voted on Fed policy with their feet. The yield curve has undergone a bear steepening as long-term rates have risen more than short-term rates. However, the shift along the three to 10-year maturity range has been parallel with a modest bulge on the five-year maturity. While yields on three, seven, and 10-year Treasuries have all climbed 29-30bps, five-year yields have risen 36bps; more than any maturity aside from the 30-year bond.
Clearly this is not what the fed had in mind in announcing QEII. First, the decision to focus on intermediate term durations likely reflects the risks and benefits associated with additional asset purchases. Purchases on the short-end would have carried minimal price risk for the Fed’s portfolio and would have had minimal impact for the same reason: short-term yields are near zero. On the other hand, focusing on the long-end would have carried significant price risk for the Fed’s portfolio and would have largely impacted mortgage rates and rates on long-term corporate debt, both of which are already at historic lows. Furthermore, lower rates will not result in significant increases in home purchases until significant headway is made in unemployment and until significant progress is made in clearing the supply of foreclosures on the market. In short, if low rates alone could have solved the housing crisis it would already have been solved. The Fed obviously concluded that buying the belly of the curve carried the best risk/reward payoff, keeping their own interest rate risk within a tolerable level and flattening the spread between short-term and intermediate term rates while modestly increasing the spread between intermediate and long-term rates.
Yet thus far this has not occurred. Over the last two weeks the Fed has faced a firestorm on all fronts. A letter, signed by 23 economists, was sent to Fed Chairman Ben Bernanke, arguing against QEII. The Administration entered the G20 Summit hoping to garner support for pressuring China to allow the Yuan to appreciate more quickly. Instead, it faced accusations of devaluing its own currency (which indeed is exactly what the Fed is doing). Finally, the market has weighed in with a clear indication that it expects QEII to be inflationary: it has pushed prices lower and yields higher on the very securities targeted by the Fed’s new purchase program.
Admittedly, two weeks is a negligible time for long-term investors. While it’s too early to declare the policy a loser, early exit polls indicate that bond investors are voting against the policy. Our own assessment is that while QEII will weaken the US Dollar and therefore be inflationary, it is far from certain that it will lift the US economy. Sadly, Ben Bernanke is likely well aware of this, yet hoping that further monetary ease will push prices of risky assets higher and that higher asset prices will beget higher GDP through the wealth affect. Unfortunately, this policy has not only been tried and found wanting, but it is one of the culprits that landed us in this mess in the first place.