After 29 months of operation, the Federal Reserve will end its large-scale asset purchase program, or quantitative easing, on March 11. While many believe the end of QE is long overdue as it stoked the inflationary fire, others suddenly find themselves facing uncertainty.
Bond investors are becoming increasingly nervous as they fear interest rates will rise without the support of the Fed.
There’s little evidence to suggest that interest rates will continue to rise and bond prices fall without the support of the Fed. Looking back to the end of quantitative easings 1, 2, and 3, yields fell at the end of each program. Despite historical evidence that suggests yields will likely fall, investors believe this time is different.
With inflation running hot and seemingly out of control, investors are certain rates must rise. Investors believe interest rates follow inflation, which isn’t true. The Consumer Price Index, the most popular measure of inflation, is a lagging indicator as it looks back at prices over the past six months. There is nothing predictive about the CPI, while Treasury yields are a leading indicator of growth and inflation expectations.
Bond investors have little to worry about as the latest bond rout is nothing more than a temporary aberration in the long-term trend of lower interest rates. Contrary to popular belief, interest rates will not continue to rise indefinitely without the support of the Fed.
There’s plenty of demand for U.S. government debt from global investors and the demand for U.S. government debt is likely to increase as the global monetary system returns to normal. Few investors understand how the global monetary system affects interest rates and why the Fed needs to periodically intervene with quantitative easing.
As the home of the world’s reserve currency, it’s the role of the United States to export dollars to the rest of the world. The U.S. achieves its goal of exporting dollars through trade. Goods and services imported into the United States are paid with dollars which are sent back overseas.
Excess dollars that are built up in foreign financial systems are recycled back to the United States through the purchase of U.S. Treasury securities. The reason foreign investors and central banks purchase U.S. Treasury securities with their dollar savings: Treasury securities pay interest, whereas dollars do not, and Treasury securities are easily converted back to dollars on the open market.
Treasury securities are how foreign investors and central banks hold their dollar savings. Due to the depth and liquidity of the U.S. Treasury market, it’s easy to sell Treasurys on the open market should there be a need for dollars.
When the global financial system is functioning normally, excess dollars will accumulate in foreign countries as a by-product of trade with the United States. Every month, foreign investors and central banks bid at the monthly Treasury auctions for newly issued Treasury securities to convert their dollar savings into interest-bearing Treasury securities.
The reason foreign bidders often take the largest percentage of a given Treasury auction is a function of amassing large quantities of dollars through trade. Barring a need for dollars, foreign investors and central banks hope to continuously accumulate Treasury securities.
As the global economy expands, more dollars flow overseas, which leads to an ever-increasing demand for U.S. Treasury securities. In an ideal situation, those Treasury securities would be held to maturity and then reinvested. Unfortunately, there are periods where the global economy contracts and foreign savers need to sell their Treasury securities to get dollars.
When the global economy slows, the federal government should also reduce its deficit spending, and perhaps run a surplus, to soak up any foreign sales of Treasury securities. Instead, the U.S. government chooses to increase its deficit spending during a recession by issuing a large amount of debt.
To mop up this extra issuance of debt that foreign investors and central banks cannot absorb, the Federal Reserve steps in with its quantitative easing program. While rates can and have risen during prior QE programs, the Fed’s large purchases likely prevent rates from rising substantially.
By engaging in quantitative easing, the Fed is merely filling in the gap of demand for U.S. Treasury securities that would normally be filled by foreign investors and central banks recycling their excess dollar savings. Once the global economy starts to exit a recession and return to normal, there’s no need for the Fed to intervene.
With a backlog of cargo ships sitting off U.S. ports waiting to import goods, and strong demand at the regular Treasury auctions from foreign bidders, there’s no need for the Fed to continue its quantitative easing program. Demand for foreign-produced goods and services remains high, and is expected to, as the global economy returns to normal.
Bondholders shouldn’t fear a secular rise in interest rates or inflation, as Treasury yields tend to fall due to strong foreign demand for Treasury securities. As long as consumers continue to demand foreign-produced goods and services, Treasury yields will likely decline in the short term and continue to decline over the long term.
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