At some point, the Federal Reserve’s policy
of Quantitative Easing (QE) will have to end. The decision for the Federal
Reserve to provide this support has been much debated. There is a real question
about what will happen when the Fed finally decides to stop giving this support
to the Treasury.
Currently, The Fed’s QE policy is
attempting to protect the Federal Government, via the US Treasury, from
exposure to higher interest rates. The
implicit goal of QE is to provide enough time so the government can resolve the
current economic crisis. More
succinctly, the Federal Reserve and the U.S. Treasury are working closely
together to make sure that the government does not have to pay market
determined interest rates for their funds.
Not feeling the restraint of
market-based borrowing costs, the Federal Government has essentially signed
itself up for a spending spree. This
gets to the heart of the basic economic problem: unlimited wants versus limited
resources. The government, being offered
cover for their actions, has blatantly showed its desire for unlimited
wants. After all, what is the demand for
something that is free? There is
unlimited, or at least theoretically, infinite demand.
Despite their best efforts, the current
actions by the Federal Reserve have stoked an inflationary concern, which has
driven up yields. The entire thesis of
the Federal Reserve action is to force interest rates lower to allow cheap
federal stimulus and easy financing for business and consumers. The Fed has now
entered a point where the inflationary concern is making their actions
counterproductive.
If they want to lower interest rates
the Fed should end the current QE policy, or at least signal the initiation of
a QE wind down.
Once Fed QE support for lower rates ends,
we can expect a large upward swing in Treasury yields. Here is why. Bond
investors, whose sole purpose for purchasing the instruments was to have the
Federal Reserve be the "greater fool," would immediately exit their
positions. However, most of the reasons for
the so-called inflation trade—the so-called “printing money” and “monetizing
the debt” strategy—will be eliminated.
Is it possible that yields will
represent a significant value at that point?
Once the interest rate on new borrowings is reflective of market-based
forces, plans for federal spending would likely be curtailed, as the government
must be reacquainted with the concept of limited resources. The resulting lower
levels of fiscal stimulus would be contractionary for
the economy.
The result of ending QE, quite counter
intuitively, is that yields could begin to fall as Treasuries look to be a
better value going forward given the rather meager growth profile of the nation
over the intermediate term. Strangely, the
Fed could get what it wants by exiting its current entanglement with Treasury.
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