This is finally banged into a form that can go out the door. The main points are as described in the preview sent out last week.
The main causes of the low term premium, and risk premia generally, are low underlying economic volatility, the inverse correlation between stock and bond returns, and the proximity of the zero bound on rates, which reduces bond yield volatility by truncating the distribution.
The size of the Fed’s balance sheet does not have much effect on the relevant premia, particularly through the duration removal and portfolio balance channels that the Fed has chosen to emphasize. This is yet another of their fibs, mostly harmless to the country, but probably worth identifying if you are an investor.
However, QE does have important signaling and behavioral effects. Importantly, these effects too can be – and have been – largely separated from the specific size of the balance sheet. What matters much more is the Fed’s take on the economy and how that links to their communication and even “tone.”
Both the determinants of volatility and the Fed’s tone are ultimately anchored in economic fundamentals, which we therefore need to continue monitoring going forward. Possible changes to the Fed’s economic objectives are also relevant, as I have discussed in earlier notes and do not elaborate on here much. * But they too are completely independent of the size of the balance sheet.
There is one idea that was not in the summary, because it occurred while writing the report. QE enthusiasts like to include the influence of other non-commercial buyers, such as foreign reserve managers, banks or even pension funds. If you incorporate their buying of default-free, pure rates duration, then you may be able to show QE as the tie breaker, tilting duration supply from ample to scarce in rate of change terms over the past decade.
I am not in that camp, for reasons I describe. But here is a related thought. It is possible that those non-commercial buyers end up pushing down the equilibrium real interest rate, thereby making the zero bound on rates more pressing, particularly in the presence of low inflation expectations. Foreign central banks move the dollar up and reduce the urgency around stoking their own domestic demand. Banks’ demand for Treasuries may be linked to financial repression, although the force of financial repression was overstated, particularly in the immediate wake of the Crisis.
To the extent that the proximity of the zero bound is the real cause behind low bond yield volatility, and to the extent that this drives the low term premium, then these QE enthusiasts may have a point. Again, though, it has nothing to do with supply or QE’s peculiar influence. I may follow up on that in a subsequent series of notes. I have learned over the years not to dismiss conclusions, even if the arguments seem wrong.
* I have been a bit surprised by how willing the Fed has proven itself to be to look for the whites of the eyes of inflation. They seem willing to tolerate a larger employment overshoot than I had imagined, even though I had already factored in that their late cycle inflation objective is closer to 2 ¼% than to 2%.