How the Fed Showed It Had the Market’s Back
Does the Federal Reserve buying fewer Treasurys make the yield of the bonds go up or down? In the topsy-turvy world of Wall Street, the answer has reversed in just a few months.
The story last summer was that quantitative tightening, or QT, meant bond yields would rise, as the Fed cut its balance sheet by buying $50 billion less Treasurys and agency securities each month. Add to that the end of net bond purchases by the European Central Bank and reduced bond buying by the Bank of Japan and many investors thought higher bond yields were on the way.
Now those same investors are leaping on hints from Fed Chairman Jerome Powell last week that QT could be ditched if necessary. Rather than send bond yields down (prices up), the idea that the Fed could buy more Treasurys each month than planned sent Treasury yields sharply up (prices down), along with stocks.
What gives? The trouble is that no one really knows for sure how quantitative easing, or QE, worked, let alone how its reversal is working. Central banks have many explanations, and most now dismiss the simple and obvious one that buying bonds just makes prices go up and yields go down (although the European Central Bank still sticks to that theory).
There are a bunch of other explanations, including a portfolio effect that forces investors to hold fewer safe Treasurys than they wanted and effects from a likely commercial bank preference for central bank reserves over other forms of liquid holdings. But the most important is the signaling effect about future monetary policy.
Very broadly, QE and QT affect both the supply of bonds to the market and the demand for bonds from the market. Fed action to reduce the supply by buying trillions of dollars of bonds and holding on to them pushes their price up and yield down, all else equal, and on the simplistic view QT should have the opposite effect.
But all else is never equal. Signaling that the Fed has your back and is ready to take extreme action reassures investors, reducing the demand for safe Treasurys — and so pushing their price down and yields up. The experience of QE in the U.S. and U.K. has shown both effects at different times, with the signaling effect frequently more than offsetting the simple impact of purchases.
Even worse, moves in currencies linked to changes in yields can offset or amplify central bank buying, too.
QT is even harder to understand. It might just be the opposite of QE. Or it might not. The Fed started to reduce its bondholdings in October 2017, with no obvious effect on bond yields — exactly as it hoped. QT initially came with no signaling about broader Fed intentions, as it was designed with a preset course of reduced Fed bondholdings. Yields on 10-year Treasurys rose over the following year by slightly less than the overnight rate.
That changed last month, when Mr. Powell perhaps inadvertently turned QT into a signaling mechanism by pointing out what was quite obvious, that QT had been working smoothly on automatic pilot. “I don’t see us changing that,” he added.
Bond yields fell (along with stocks) as the signaling effect overwhelmed the impact of continued Fed cutbacks in bonds. Investors feared that Mr. Powell wasn’t prepared to take extreme measures to keep the economy on track or to prevent a bigger market fall.
It took until last Friday for Mr. Powell to reverse course, and his signaling this time worked effectively.
“If we came to the view that the balance sheet normalization plan or any other aspect of normalization was part of the problem, we wouldn’t hesitate to make a change,” he said in Atlanta.
The Fed once again has your back. And once again the signaling effect overwhelmed the simple mechanical effect of buying and selling bonds. Treasury yields rose sharply, rather than falling as the prospect of more Fed buying might suggest. The beaten-up stock market has put in a stunning rebound since.
Thursday produced another baffling market response for those who think Fed bond buying should make yields go down. Mr. Powell said he expected the balance sheet to be substantially smaller in the future, and yields went up — although he also emphasized the Fed was not committed to rate increases, the traditional way for the Fed to send a dovish signal.
There are several lessons for investors. First, accept that even central bankers don’t properly understand how QE and QT works, and most investors are thoroughly confused about the entire monetary system. Treat Wall Street claims about what the effect of QE or QT is likely to be with deep skepticism.
Second, accept that this confusion is likely to drive markets. To some extent it doesn’t matter to investors what impact Fed action has on the plumbing of the financial system; what matters is what other investors think the Fed is doing. If everyone is suddenly willing to buy risky stocks and sell safe Treasurys because they think the Fed will help, that will make stocks and Treasury yields go up, whether or not the Fed really has support on standby.
As of last week investors concluded that the Fed is willing to act if the economy gets too weak or — perhaps — if the market falls too much. The exact size of Fed bond buying each month is far less important than the signal the Fed sends about it, and Mr. Powell’s signal was a green light. Only if the economy or markets get into more trouble will we find out whether the Fed is actually ready to help.
Source: Dow Jones