Authored by Peter Cook via RealInvestmentAdvice.com,
In “The Fed’s Real Target” it was explained that the Fed’s interest rate manipulations are intended to influence the behavior of borrowers, not investors. Fed Chairman Powell agrees. In his most recent press conference, Powell reiterated that the Fed Funds rate continues to be the Fed’s primary tool to influence the U.S. economy. Based on the Fed’s analytical framework, the economy is slowed by a series of interest rates increases because the behavior of borrowers is constrained. Using similar logic, the economy is stimulated by a series of interest rates declines because borrowers use the reduction in interest expense for other purposes that promote economic growth.
But the Fed also bought a non-trivial amount ($3.6 trillion) of government obligations during the Quantitative Easing (QE) experiment, in the belief that QE would also boost the U.S. economy. Unlike interest rate manipulations, QE is direct manipulation of bond prices and yields and is clearly directed at investors, not borrowers. This key difference between who QE and QT targets are incredibly important and often not fully appreciated by investors.
Since November 2017, the Fed has embarked on Quantitative Tightening (QT), a policy that forces investors to refinance trillions of U.S. government obligations that are maturing from the Fed’s portfolio.
Can the movement of asset prices during the QE period give clues about how asset prices might move during QT?
In this article, we show that the Fed’s QE policy produced the counterintuitive result of higher yields on Treasury bonds, not lower yields as implied by supply/demand analysis. Using symmetrical logic, the Fed’s QT policy should be expected to reverse the effects of QE, and to produce the counterintuitive result of lower yields, not higher yields implied by supply/demand analysis.
QE was launched in 2008 and ended in late 2014 after three rounds of purchases plus Operation Twist which extended the duration of their holdings Digging through the archives, the following chart shows that the S&P 500 index (SPX) rose 176% during the periods in which QE was operative (colored lines) while SPX declined 32% during non-QE periods (gray). Since mid-2015, when the chart was created, SPX has risen from 2100 to 2785, a gain of 31% that offset almost all the 32% loss. Clearly, QE produced an upward bias to stock prices. While the topic for another article, it is worth pointing out that many other central banks continued buying assets after QE ended via their QE programs and this activity played a role directly and indirectly in supporting SPX.
Moving to the market for U.S. Treasury bonds, QE produced quite a different result than many had expected. The 10-year Treasury yield rose by 184bp during periods of QE and fell by 293bp during non-QE periods. Despite massive bond purchases by the Fed, sales by other investors overwhelmed the Fed’s actions. Since mid-2015, when the chart below was created, 10-year Treasury yields have...