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Fedspeak? Get A Load Of That BULL!
Quantitative Easing, Interest Rates, Yield Curves And What The Fed Said.

Sebastião Buck Tocalino,
November 24, 2014

  • Most people got it wrong, Quantitative Easing did not lower long-term interest rates!
  • The Federal Reserve's money printing actually halted the plunge of yields and cheapened bonds.
  • Yields fell due to other institutions showing their appetite for long bonds, and that suggests trouble ahead.
  • Remember all those speeches about the Federal Reserve printing money and buying long maturity debt securities to bring down interest rates? Supposedly, the purpose was to make long-term yields less attractive to Wall Street portfolios while boosting loans for more productive investments in the real economy of Main Street. We all heard that line before, didn't we?

    I have been collecting data for a retrospective look at Quantitative Easing, interest rates, gold and the U.S. Dollar. A lot of it just confirms what I had covered on this paper published in 2011. In that year, the U.S. Dollar Index (a measure of the United States dollar relative to a basket of foreign currencies) had averaged around 76.00 or 77.00 and the PowerShares DB US Dollar Index Bullish Fund (UUP) had bottomed at 20.84, while the ounce of gold had peaked around US$ 1,900!

    This week, while charting some of the data, I was very entertained with one chart in particular. It shows the yields on actively traded non-inflation-indexed 30-Year Treasury issues adjusted to constant maturities (long-term interest rates). Though they back up my point of view, they surely contradict a lot of that Fedspeak we were given. Fedspeak is that turgid dialect of English used by Federal Reserve Board chairmen (or chairwoman) in making wordy, vague, and ambiguous statements as a strategy to prevent financial markets from overreacting to their official remarks. Anyway, the subject still seems little noticed or understood by most people (including lots of old time investors and writers). People have bought gold and inflation fear instead of the U.S. Dollar and disinflation/deflation, which I have been advocating for years.

    Before casting eyes on the chart ahead, it is important to fully understand the dynamics of the inverse relationship between the market price paid for these instruments and the interest rates they will pay (yields in percent per annum). These assets have a predetermined value for their date of expiration (maturity). What will set the interest rate they will pay (their yield) is the price they are bought for. The fewer the buyers out there, the weaker the demand and the cheaper the price that these instruments will be negotiated at, therefore, the spread between market price and maturity value gets larger, which means better yields with higher interest rates. When the buying demand grows faster than the offer of such instruments, than their market prices go up, narrowing the spread to their maturity value and, consequently, lowering their yields (interest rates go down).

    In a nutshell:

  • Bond prices and bond yields move in opposite directions;
  • More buyers will push the prices of Treasuries higher and thus lower their yields (interest rates fall);
  • Fewer buyers will lead to cheaper Treasuries and higher yields (interest rates goes up).
  • So it may really make sense when the FOMC says it will lower long-term interest rates by printing money and buying long-term securities in the market. But, if these rates are already coming down, does the FED just want to rush them down even faster? After all, by joining the elbowing crowd of buyers, the FED should indeed inflate buyers demand and push prices higher, lowering their yields.

    In any case, if lowering long-term interest rates was their real intention, this next chart does not portrait such proposed intention. It just shows us the facts of the matter:

    juros nominais de 30 anos

    Note that each time the FED stepped in with some Quantitative Easing to buy debt securities in the secondary market, the results were that long-term interest rates stopped falling. Indeed they gained strength to go back up again. Wait a second! The opposite of the FED's declared intentions? Could there have been a drop in the buying demand as soon as the FED started buying? What happened to the other bidders? Did banks just step back and bow in reverence to the FED's entrance? It is clear for all to see that rates resumed their fall as soon as the FED waved goodbye, leaving market participants on their own again. When markets act alone, that's when yields go down! The moment commercial banks and private funds don't see any central bank action is when they come in crowds to buy these Treasuries, lifting their prices and plummeting long-term interest rates. Check out how fast they dropped before QE1 and then again at the end of QE1 and QE2.

    Now that QE3 is finally over, we will have a chance to see what happens next. If QE3's tapering may serve as a clue, we should see more of that same behavior. The Fed's 10-month-long tapering in 2014 allowed rates to go slowly down again from that 3.96% peak at the end of 2013. So the FED's gradual exit from the market had the effect of actually augmenting the demand for these instruments. Other institutions' bids were obviously swelling faster than the rate of tapering on the FED's part. It wasn't the FED's purchases that were bringing interest rates down!

    Take a good look at the difference between the 3rd and the 4th quarter of 2011. If you pay attention to operation TWIST (as another example of interference, this time with no money printing involved) you will see that, as soon as it was announced in September 2011, rates halted their rapid plunge from the end of QE2. TWIST was just shifting the duration of the FED's portfolio. By selling its short-term securities (with maturities of less than three years) and buying instead long-term debt (with maturities ranging between 6 and 30 years), the Fed wanted to narrow the spread between short and long-term rates, what would flatten the yield curve. To be fair, long-term rates did drop during this TWIST, but at a fraction of the speed they were falling before it started!

    If QE was effectively halting the drop of the long yields and pushing them up again, then it was increasing their attractiveness as "parking space" for nonproductive capital from banks and funds. So central bank interference was not helping productive investments, since it was not lowering long-term interest rates. It was really raising interest rates and diverting money that could be invested in the real economy (to develop new small businesses, grow others and finance the fixed capital of physical assets, capital goods and the creation of more jobs). But if these were the facts, how can the FED find a palatable justification or formal explanation for its recurring action? Of course the intuitive answer is that they were more inclined to strengthen the banks than anything else! But it would be extremely daring to explain this to the majority of the population (those undignified 99% that were represented by the Occupy Wall Street movement that even George Soros, among others, sympathized with) and justify any money printing if -in practice- this was just making money more expensive for the businesses of Main Street.

    Like before, during most of QE3 (from September 2012 to January 2014) interest rates were really going up! They only started to drop from January on, when the FED began to taper its purchases of securities and slowed their money-printing presses. They diminished their monthly interference until coming to a complete stop last month (October, 2014). If rates went down, it means that others started to buy 30-year Treasuries with a lot more gusto than the FED did. And that is NOT a good omen for things to come!

    But the question still echoes from those hollowed discourses: how do we explain the FED's attitude, indeed coming to the rescue of higher long-term rates instead of lowering them as they had often advertised?

    With each new edition of Quantitative Easing, the Fed seemed to scatter away the institutions that were buying these very long-term securities. With the resulting slack of bids, prices came down, even though the FED was printing money to buy them. The continuing remission in prices meant that these securities were offering again higher and higher yields throughout the QE interventions. At the end of a QE, the FED would step out leaving new bargains for commercial and private banks and funds to pick up from the Treasury's issuance. These institutions would crowd together for the auctions and quickly grow their bond purchases, inflating their prices again and bringing down the interest rates they paid. When these securities got considerably more expensive and yields too low, good old FED would come back to the rescue. Once more a sea of bidders would part and freeze to let the Fed through. This exodus allowed less buying pressure and resulted in a drop of security prices, thus the FED promoted again higher yields and cheaper Treasury Bonds that other institutions could come back to lift away from the U.S. Department of the Treasury.

    Long-term interest rates fall due to the actual fears and constraints hidden in this economy, and not thanks to the FED's asset purchases with freshly minted money.

    The Federal Reserve is hinting an implicit, though obviously not outspoken, concern for the banks' situation and their preparedness for things yet to come (mind that a broader private sector deleveraging is yet to come stronger, and not only in the U.S. of A. - check out this world economy report here from Geneva)! If there was a bubble in the U.S. bond market, I do not believe the FOMC would let these banks jeopardize themselves and the whole economy so soon AGAIN. It is true that they did it before, but the FED seems to be willingly helping banks in strengthening their positions with long bonds, so that they may be cushioned for the havoc that still lurks in the shadows.

    But I do not believe the same applies to the U. S. stock market. Whereas the already desperate Bank of Japan had to abandon whatever caution was left and succumb to buying stocks, since they are running out of choices, the FED seems neither that desperate nor that foolish. Besides, with some of the spare money that was created and infiltrated into the economy, stocks have already moved way up there. Each Quantitative Easing made bonds cheaper and more attractive for the banks to buy more from the Treasury, but the opposite happened to stocks. Stocks just got more expensive, they are riskier and less attractive now.

    Though the U.S. stock market is way up there at record levels, bank stocks are not. And they are the institutions that deleveraged the most in the private sector! With some precious help from the FED! It is no wonder that Warren Buffett's Berkshire Hathaway invested US$ 5 Billion in Bank of America, back in 2011, when its stocks were valued around US$ 6.00. The announcement was made just a few weeks before operation TWIST was initiated. The FED's action avoided that the commercial bank kept paying increasingly more for fixed rate securities with lower yields, while avoiding a bear market in stocks. That Oracle of Omaha may be getting old, but he can still think things over a lot faster than most investors who were gullible enough to fall for all that Fedspeak.

    Warren Buffett's investment in Bank Of America

    When negotiating these long-term Treasury bonds, it is obviously important to take into account the perspectives for the consumer price index (CPI). Whatever the expectations for inflation (or disinflation and deflation), they are pondered before any purchases are made. Aiming for a better retrospective approach when viewing each period (with and without QE), I have visited the U.S. Department of the Treasury website to examine historical yield curves and check on the nominal and REAL yields. After all, real yield is what everyone is after!

    I am including here the charted yield curves for all the different periods, from Lehman's collapse to last month's end of QE3. The bigger charts on the left side represent the nominal yield curves for the Treasuries, while the smaller charts on the right show the real yield curves. (Treasury Bills or T-Bills = maturities are less than a year; Treasury Notes or T-Notes = maturities between 1 and 10 years; Treasury Bonds or T-Bonds = maturities of 20 or 30 years)

    Lehman Brothers' bankruptcy on Sep-15-2008 put most people that dealt with finances and Wall Street in a state of panic. The reflexes on Main Street were noticed very fast through the consumer price index and the unemployment rate. Annual inflation dropped from 4.94% in that month of September to a nearly flat 0.09% by the end of 2008, then it turned into a deepening deflation until July 2009, when it bottomed at -2.1%. With that disinflation and deflation scenario, even though nominal interest rates were going down, real yields were actually going up and becoming more attractive. Remember that real interest rates are the nominal rates minus inflation. Since inflation was shrinking there would be less to subtract from nominal rates, and once deflation (which is negative inflation) gets going, subtracting a negative rate is actually an addition to nominal rates. So, in the aftermath of Lehman, the FED was justified in launching QE1. In that first event, the FED's money printing (and buying mostly Mortgage-Backed Securities) did indeed bring down long-term real interest rates.

    yield curve


    yield curve

    The next chart shows that in that first Quantitative Easing, the FED bought more GSEs Mortgage-Backed Securities than Treasuries.

    assets bought by the FED along QEs

    In the following period, without any QE intervention, the market on its own was bringing down the interest rates (institutions were buying more Treasuries).

    yield curve

    But with QE2 starting November 2010, the FED was again printing money to buy assets. Only this time, it focused on Treasuries instead of Mortgage-Backed Securities (that chart above shows the different patterns in both kinds of securities purchased by the FED throughout QE1, QE2, TWIST and QE3). As we can see, only QE1 lowered long-term real interest rates. Later, QE2 and QE3 just halted the plunge of nominal and real yields to push them up again.

    yield curve


    yield curve


    yield curve


    yield curve

    In 2014, we could finally see rates starting to drop again as the FED tapered QE3. It was gradually tinkering less with the market and the monetary base.

    Not only commercial banks and private funds are buying these long U.S. T-Bonds, foreign central banks are also buying them. I will repeat what I wrote before: if rates came down, it means that others started buying 30-year Treasuries with a lot more gusto than the FED did. And that is NOT a good omen for things to come!

    And so, what was that load of Fedspeak really all about? Whatever it was, the BULL thrived on it!



    Copyright © Sebastião Buck Tocalino - All rights reserved.

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