The End of QE2: Does It Matter?

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Some high-profile portfolio managers and financial commentators have been warning investors about a potential D-Day on June 30 when the Fed’s QE2 program of Treasury bond purchases winds down. These analysts claim that since Fed purchases have accounted for a very large percentage of Treasury issuances in the past few months that the exit of the Fed from the market should cause yields to rise substantially.

In this article, I would briefly like to point out some factors that need to be taken into account when trying to analyze the potential impacts of the winding down of QE2. I would ask readers to pay special attention to point No. 6.

1. Expectations matter. Considering that the market has had six months to fully prepare for the exit of the Fed from the market, one would have to believe that the market was completely useless to justify the thesis that yields will rise dramatically after June 30. Debates about the Efficient Market Hypothesis aside, such a notion is implausible. Expectations do matter.

2. Historical experience. Those that believe that the withdrawal of the Fed from the market will cause rates to rise do not have historical experience on their side. For example, when QE1 ended, rates actually fell. More recently, when QE2 commenced, rates actually rose, a fact which runs counter the theory offered by those that think rates fall when the Fed purchases Treasuries and then fall when the Fed stops purchasing. Finally, the recent end of the QE program in the UK was actually followed by a steep decline in rates.

3. Portfolio balance. Because the Fed can be considered to be a hold-to-maturity owner of Treasuries, speculative holders of US treasuries are essentially being crowded out in favor of longer-term investors that typically are not inclined to sell. The resulting portfolio balance therefore favors marginally lower long term risk premia, and concomitantly lower long-term Treasury yields.

4. Fed tightening should lead to lower yields. There is a certain hypocrisy that reveals itself in certain critics of the QE2 program. Most of these critics attacked the program due to its supposedly inflationary consequences. Now that the program is being wound down, those critics should be celebrating and projecting lower long term interest rates since the Fed is no longer “monetizing” debt and generating inflationary risks. But these critics are now claiming that rates will rise with the end of QE2. For these critics it’s heads I win, tails you lose.

The same theory that caused analysts to criticize QE2 should lead them to predict that rates will fall after QE2 ends. Winding down extraordinarily easy monetary policies should normally be considered to be bullish for bonds.

5. QE2 was largely a non-event in terms of Treasury yields; so too its end. As I have pointed out is various previous articles (see QE2 May Not Prevent a Rout in US Bond Markets), QE2 was something of a non-event as far as Treasury yields were concerned. QE2 represented less than 0.0002% of total global fixed income trading volume during the period in which it was implemented. Why use figures for global fixed income trading volume? Arbitrage. All fixed income markets are linked. Flows in or out of US Treasuries will be met by counteracting flows from the rest of the market so that relative rates are equilibrated at the level deemed appropriate by market participants. Thus, since QE2 was of miniscule importance to the bond market in terms of stocks or flows, and the winding down of the program should be expected to be similarly insignificant.

6. Money and credit. Many people are under the impression that QE2 had a substantial expansionary effect on the broad money supply. This impression is false. The broad money supply, defined as M2 or MZM, is around 9 and 10 trillion USD, respectively. As a point of fact, since QE2 was implemented, M2 and MZM expanded by less than 200 billion USD. In other words, QE2 expanded the broad money supply by substantially less than the program’s 600 billion nominal value. The implication is that the underlying organic money supply has actually been contracting and QE2 has merely served the function of counteracting this effect.

It is important that people understand this. As I have explained many times in my writings (e.g. Sobering Message From Fed's Kocherlakota: Fed Not as Powerful as Many Think; Will QE2 Lead to High Inflation? and QE2 Preview: How Much Is Too Little or Too Much?), the purpose of QE2 was not to significantly expand the money supply. The purpose of the program was to counteract what would otherwise have been a brutal organic contraction of the money supply.

In modern monetary systems the vast majority of money is not created by the central bank, but emerges endogenously through the banking system via the expansion of credit.

In modern monetary systems, money is credit. Because endogenous forces were causing a contraction of the money supply via the process of deleveraging (i.e. credit contraction) and a reverse money multiplier effect, the Fed intervened to maintain broad monetary aggregates stable and head off a massive contraction of the money supply and concomitant liquidity crisis that would otherwise have occurred.

Therefore the key to determining what effect the winding down of QE2 might have on the economy is to ascertain trends in the quantity of credit. If credit begins to expand, even moderately, the exit of the Fed from credit markets will hardly be felt.

Assuming a modest money multiplier, I believe that all that is needed for the money supply to remain accommodative to economic expansion is annualized credit growth of about 3% in the second half of 2011. However, this is the potential fly in the ointment. In aggregate, credit has not yet begun to expand in the US. Indeed, overall credit appears to continue to contract marginally.

Under such circumstances, withdrawal of Fed liquidity support could prove to be untimely.

On the other hand, there are some reasons to be sanguine. Most concurrent and leading indicators of economic activity point to a firming of aggregate private sector demand in both the consumer and business segments. Given substantial pent-up demand and expanding employment, it is reasonable to expect that credit might soon start to grow at a healthy rate.

In this regard, banks have gone a very long way towards cleaning up their portfolios and capital ratios. In this regard, it is important to note that banks are holding massive amounts of idle liquidity in the form of reserves. Bank managers and regulators may finally be ready for banks to resume lending.

All that is needed is a slight decline in risk aversion amongst banks, regulators, consumers and business for credit behavior to normalize relative to the current phase of the economic expansion.

The Difference Between Rates and Liquidity

QE2 was designed to counteract a contraction in liquidity, not so much to lower Treasury rates. Liquidity is related to rates. But they are not the same thing, and the relationship is not simple.

If liquidity contracted in the financial system, long term Treasury yields might actually fall. This is what occurred in 2008.

That is why there is no necessary contradiction between my contention in points 1-5 above that QE2 was a non-event in terms of Treasury bond yields and my discussion in point No. 6 highlighting the importance of QE2 in terms of preserving an adequate level of liquidity in the financial system that is supportive of economic growth.

QE2 was and is very important to liquidity and the prospects for economic growth. QE2’s impact on long-term interest rates is far more subtle and ambiguous.

Conclusion

The impact of QE2 on interest rates has been and will remain complex. Its direct impact on rates has probably been and will likely remain negligible. However, the indirect effects of QE2 on interest rates and the economy as a whole via liquidity effects bear careful scrutiny.

It is important to understand that the purpose of QE2 was to counteract an organic contraction of the money supply caused by deleveraging. Its ultimate success depends upon there evolving an effective “hand off” between Fed-provided liquidity and liquidity provided by the banking system.

Liquidity refers to money, and money is credit. Despite some hopeful leading signs, credit has not yet begun to expand and may still be contracting. Unless credit begins to grow, thereby expanding the money supply organically and “picking up where the Fed left off” in terms of providing liquidity to money markets, the winding down of QE2 on June 30 could prove to be untimely.

In any event, please note that an unsuccessful “hand off” of Fed asset purchases to private lending would, in the short term, just as likely be accompanied by a decline in Treasury rates as a rise in UST rates due to its recessionary consequences.

A successful exit from QE2 is dependent upon the reactivation of credit markets and the concomitant organic expansion of the money supply.

Thus, investors need to focus on credit. Similarly, the Fed and other relevant US officials must focus on policies that enable and encourage banks to deploy their copious reserves and resume the expansion of lending. If lending resumes, either assisted or unassisted by government policy, QE2 will pass as a non-event. If credit stagnates or contracts, it will be time for all of us to start worrying.

As I have made clear to readers in recent articles, I expect a relatively happy outcome, based on my interpretation of trends in aggregate demand. But if readers want to know what would cause me to change my bullish stance on the US economy or stock market, it would be a scenario in which QE ends (and is not replaced by anything), credit growth has not resumed and money market spreads begin to widen due to illiquidity. Such a scenario, if it persisted for long, would doom the US economy and equity markets.

Investors may want to take a close look at financials such as Bank of America (BAC), Citigroup (C), Morgan Stanley (MS) and (XLF), (IYF), (IYG), and (VFH) on the short side or long side depending on their outlook. The financial sector will be highly sensitive to the successful or unsuccessful wind-down of QE2.

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