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Or, supply dynamics in quantitative easing. Required reading for a quiet Wednesday, really.
Remember how QE works. The Federal Reserve buys US Treasuries from investors in the hopes of pushing them into things like corporate credit, but at the same time the central bank’s purchases decrease UST supply. They squeeze investors from ‘safe’ US Treasuries into riskier assets.
But there’s supply and demand are at work. Low interest rates increase demand for higher-yielding securities, as Citigroup’s Matt King argued on Wednesday. QEasing decreases supply of US Treasuries.
With that in mind, here’s some more from Deutsche Bank’s Dominic Konstam:
The consensus concern for the end of QE2 is the potential for higher Treasury yields. In a "stock" view of the world, yields are lower than they would otherwise be, because the NPV of available Treasury supply is lower while the Fed does QE2. The end of QE2 may bring forward expectations for asset sales so yields may rise as a result. There may also be a flow effect which pushes yields higher. We can illustrate the shift in of the supply curve for Treasury debt that is available to investors in the chart below.
Now consider the impact on risk assets. Treasuries are a substitute for other assets but they become less appealing as their price rises. This effectively allows demand for risk assets to shift up and to the right. For any supply curve of risk assets this implies that risk asset prices should have a combination of price and quantity supplied increases. The nature of that supply is in terms of securities issued and loans made. The bank multiplier is a critical part of this in that the banks would use the deposits created by the Fed's QE to finance increased borrowing.
Conceptually the more sensitive loan or security supply to price, the less the actual price increases and the more supply increases. This is shown in the second chart in terms of the difference between p1q1 and p2q2. The very fact that net supply of new debt and bank lending has been weak strongly suggests that the impact of QE2 has been a risk asset price phenomenon and not a loan creation phenomenon. In other words broken bank balance sheets have simply allowed for the crowding out of Treasuries into limited risk assets with price gains more exaggerated than they would have been in an economy with a well functioning banking system.
This is important for several reasons. First, it doesn't mean QE2 was a waste of time. On the contrary, the alternative may have been much worse. Loans may have been destroyed at an even faster pace. Second, the mere end of QE2 may result in sharp declines in risk asset prices. Third, the actual withdrawal of QE2 could be very damaging "“ and interrupt any rise in Treasury yields that might otherwise be occurring. Fourth, it suggests that the Fed may tread very softly around the end of QE2. I.e. it would be risky for them to use the end of QE2 as a segue to either asset sales or changing the language. On the contrary, the end of QE2 may be surrounded by more dovish rhetoric, not less.
Focus on that supply dynamic.
Deutsche Bank estimated just after QE2 started that there were $1,100bn worth of USTs available for the Fed to purchase under its 35 per cent Soma limits. Upping that limit to say, 50 per cent, would have increased the number to $2,000bn "” more than the estimated new US Treasury issuance for all of this year. The US central bank ended up tweaking its Soma limits in November, weeks after QE2 started.
If markets are betting on QE3, it might be worth asking whether theTreasury issuance needed for such an operation will be there, what with rating agency sabre-rattling over US debt, and budget politicking.
In the meantime US Treasury market ‘tightness’ is evident here, here or here.
Related link: A large dislocation in the repo markets - FT Alphaville QEased credit "“ but maybe not for long - FT Alphaville More on the literal Bernanke put – FT Alphaville
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