Quantitative easing simply means that the Federal Reserve has become a new buyer of US treasuries, primarily the 10 year note. One theory for why the Fed is buying 10 year notes is because many adjustable rate mortgages are based on the 10 year note. When the yield on the 10 year note falls, adjustable rate mortgages remain cheap. This results in fewer foreclosures and is in the Fed's best interest because fewer foreclosures means fewer troubles for the big banks who are close to, or over the edge already. Destabilization of a large bank would create a severe economic shock that the Fed wishes to avoid and this is one (rather expensive) trick to head off that situation. So by this reasoning, the Fed should be able to throw a large sum of money at the 10 year note and drive down yields. But it doesn't seem to be working. Why?
First, to simplify the discussion, let's abandon the question of rates and simply focus on the price of treasuries. The rate (a.k.a. yield) is simply a calculation based on the price of a security and how much it pays. Every asset has a yield (or a theoretical yield) and every asset has a price. Because the Fed wishes yields to go down and they therefore wish prices to go up. This should be easy peasy. Typically, when demand for an asset outstrips supply the price goes up so create demand right? Those who are old enough can remember the demand for Cabbage Patch dolls in the 1980s and how the price of those dolls went through the roof. Likewise, when a snowstorm threatens, demand for gasoline and milk is created and the price goes up (wherever law permits). One would think that a buyer stepping in with $600 billion of freshly minted money would cause prices to go up!
The Fed however is not market demand. The main difference between the Fed and organic demand is that the Fed is a "sure thing". They have announced the intention of buying up these securities and they have even done so with a time frame. As such any one who owns treasuries, any potential seller, has additional variables to consider in this situation than they would in one where prices were going up for some unknown reason (market conditions). Unlike a bull market run, sellers right now are reasonably sure when this run will end. That means that they must consider what will happen when the run ends, that is, what will happen when the Fed stops buying? This is akin to when the used car salesman says that the price is only good for today.
I believe that this consideration results in the paradoxical effect of prices going down while the Fed is buying. What it shows is that supply actually outstrips demand. That is, there existed a pent up desire to sell these securities before the Fed stepped in. Those sellers were either on the fence or they were waiting for market conditions to create the right price to sell. Now however, the Fed represents a certain buyer. The Fed represents liquidity and it is not clear if that liquidity will still exist after the Fed stops buying. So anyone who wishes to get out of treasuries might be smart to get out now while a buyer exists. If no buyers exist in a few months then their treasuries might be worth even less.
Why would one want to sell their treasuries? It probably depends on who the owner of the securities is. As it stands, these securities are owned by almost everyone: individual investors, banks, institutional investors (pensions and college endowments for instance), state and local governments, corporations and of course foreign investors and foreign governments. It is therefore hard to tell exactly what is driving the phenomenon. Still there are a few distinct possibilities that we can focus on:
1) Reallocate capital - Those who are bullish may perceive an opportunity to move their capital from treasuries to other investments. Losing 20 or 30 basis points on a treasury by selling now may be incidental if one wishes to purchase equities or commodities with perceived double digit gains. Individual and institutional investors are likely to fall into this camp.
2) Liquidity - Institutions may want to take advantage of instant liquidity in order to pay off debt, make loans or build cash pools for acquisitions or expansion. Banks, corporations and municipalities are likely to fall into this camp.
3) Move along the curve - The US treasury still represents the safest investment in the world and many wish to stay in that investment but there remains the question of which treasury to own. One might wish to move into the 2 year (to increase liquidity) or the 30 year (to increase yield) and just be waiting for the right opportunity. With $600 billion of liquidity, investors can make large moves without roiling markets. Foreign governments would likely fall into this camp.
Seen in this light one might be less surprised by the unexpected drop in price (and thus rise in yield) of treasuries. The main question for investors then to consider is: what happens when the Fed stops buying? What we know is that there will at that point be $600 billion of additional cash in the system. There are again a few possibilities for what that might imply:
1) If the market is booming then that cash will likely circulate through assets and create upward momentum for the stock market and commodity prices. That is, it might fuel a bubble.
2) If the economy is booming then that cash will likely be used to fund corporate expansion and be channeled into new loans.
3) If neither the economy nor the market are booming then that cash will be sitting in bank accounts earning 0%.
Possibility number 3 is what happened during the last bout of quantitative easing. Rates rose during the entire period that the Fed was buying securities but when the liquidity spigot shut off rates fell off of a cliff. Suddenly there were a few trillion dollars of cash earning 0% and nowhere good to put that money. Owners immediately looked to earn more on their cash and thus began buying back the treasuries - which then drove down rates. So really the Fed achieved it's goal but it was a delayed effect. It should also be noted that during the previous QE period the US Treasury Department was selling an unprecedented amount of debt in order to fund the growing deficit and fiscal stimulus. So even despite that additional supply, rates continued to sink. One might expect a similar replay and perhaps an even steeper dive in rates absent an additional government spending binge. But one should also not discount the possibility of further rises in stock, bond and commodity prices as this new cash joins existing cash in the chase for yield.
