Quantitative easing, or QE, became a staple phrase in 2009 when central banks around the world had to deal with the effects of the global financial meltdown and the worst recession to hit developed economies since the 1930s. Now it is back in the news as a new bout of worries keep financial policymakers up at night. Although the phrase is widely used it is little understood. The purpose of this post is to explain what quantitative easing means, how it fits into the arsenal of central bank weapons to fight financial and economic malaise, and what the implications of QE policies can be for investors.
Central banks employ various policy tools in pursuit of some combination of stable prices and full employment. The traditional means of influencing monetary policy is via open market operations in short term lending markets: stimulating the creation of credit through low interest rates when the economy is sluggish, and putting the brakes on overheating via higher interest rates. In the US the Federal Reserve System uses open market operations to achieve targets for the Fed funds rate, which reflects overnight lending between banks and is thus a key measure of liquidity available in the system for credit creation.
As the economy plunged into deep recession in 2008 the Fed brought short term rates effectively down to zero, where they have remained since. That left it without the means to achieve further stimulus by its traditional tools, so Fed Chairman Ben Bernanke and his team had to come up with unconventional approaches. Quantitative easing was the product of this effort, and the Fed launched its first program in March 2009.
What happens in a quantitative easing environment is that the Fed commits to buy long-term assets like mortgage-backed and other government agency securities. How does the Fed “buy” these assets? Simply by printing new money. The theoretical assumptions behind this are fairly simple: by purchasing large amounts of assets the Fed can influence interest rates at the long end of the yield curve as well as its traditional turf at the short end. Over the course of its monetary easing operations in 2009 the Fed ran up a balance sheet of about $2 trillion worth of securities. In hindsight this program was deemed to have a meaningful impact on long term interest rates (like mortgages, auto loans and unsecured bank credit) as these rates gradually fell over the course of the year, making credit more available on better terms to households and businesses.
When QE appeared back in the headlines in July it was the result of several months of deliberations at the Fed about how to deal with a slowing economy and the attendant risk of return to recession. Quantitative easing is not a free lunch – new money that comes into the system can have long term negative effects on inflation, the value of the national currency and so forth. Policymakers want to use it only when conditions appear sufficiently alarming, and within the Fed there was dissension among members of the Board of Governors about whether conditions in the early 3rd quarter of 2010 warranted the potential risks of more stimulus measures.
The Fed ultimately decided to buy time. A portion of the securities it had purchased in the 2009 QE program were coming due in August 2010 – about $200 billion worth. The original intention had been to let these come due and effectively “retire” that portion of the money. Think of it this way – if the Fed’s balance sheet after the 2009 QE purchases was $2 trillion, then by retiring $200 billion worth of securities the resulting balance sheet would be $1.8 trillion – and so on until all funds were retired. What the Fed did instead was to reinvest the proceeds from the $200 billion coming due – but into US Treasury notes rather than new mortgage-backed securities. The Fed effectively kept the “balance sheet” at $2 trillion, neither creating nor retiring money. In other words this action was not so much a “quantitative easing” as a “quantitative marking time”.
So what happens next and why do you care? It’s difficult to predict with confidence. If the Fed does not act with further QE – in other words increasing the balance sheet to more than $2 trillion – then it is quite possible that long-term rates could rise considerably. Right now the 10-year US Treasury bond is yielding around 2.6%, a historically low level. In part that low yield is driven by a safe-haven mentality: investors have moved funds out of riskier assets like equities and into low-risk US government debt. The case for those long term rates going up would be that, in the absence of central bank intervention, economic pressures will mount and even the traditional Treasury haven won’t look so safe.
The irony, though, is that QE stimulus if enacted may not have the desired effect of bringing long term rates down. This scenario could play out if investors – and in particular foreign central banks like China’s that hold trillions of dollars worth of Treasuries – become convinced that the magnitude of stimulus is unsustainable and will have a very negative impact on US economic health for years to come, with the result of selling Treasuries back into the market, or at least not having the same appetite for new issues, and thus axiomatically forcing their yields higher.
With or without quantitative easing, in other words, there is a reasonable case to make that the low yields prevailing in the market today won’t last and can only head higher. If that is the case then you do not want to be actively buying bonds at today’s low levels. Simply by increasing from 2.6% to 4.0%, an increase in Treasury yields could cause double-digit losses on existing bond portfolios. Of course, as always there is a case to make for the other side. But it is worth proceeding with caution.
