Monday, May 27, 2013

QE & Bond Yields (excerpt)

Also unsettling stock markets around the world last week was the big backup in government bond yields. In Japan, the 10-year yield has jumped from a record low of 0.45% on April 4, 2013 to 0.85% on Friday. It briefly touched 1.0% last Thursday. In the US, investors were spooked to see the 10-year yield back over 2% for the first time since March 15, 2013. It’s also back to the dividend yield of the S&P 500.

The rise in bond yields, particularly in Japan and the US, complicates life for all the central bankers who have been pushing the outer limits of QE. To keep us from going into the darkness, they have taken us to the brink of monetary policy's final frontier. The positive interpretation is that bond investors have concluded that the central bankers will succeed in stimulating self-sustaining economic growth and in boosting inflation rates. If so, then the monetary authorities do need to provide a credible exit plan from QE that won’t push yields back up to levels that depress economic activity. Alternatively, central bankers are in a Catch 22 situation in which rising yields depress economic growth, forcing the continuation of QE or even more of it! What should they do?

What can they do? What will they do? When he was just a simple Fed governor, Ben Bernanke provided the answer in a remarkable speech on November 21, 2002 titled, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” In it, he listed all the possible tools that central banks could use to avert deflation including ZIRP, QE, and even printing money. The major central banks have followed Bernanke’s advice except for actually running the printing presses, which is the ultimate final frontier of monetary policy.

However, other than printing money, there is still one tool mentioned by Bernanke that has not been used, i.e., pegging bond yields. Here is what he had to say on the subject: “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt….”

Back then, he focused on doing so for the two-year note: “The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.”

Why not just go for it and peg the 10-year Treasury at 1.50% in the US and the 10-year JGB at 0.50%? This would be a variation on current QE programs that don’t specify any target levels for the yields of the bonds that are being purchased. That’s too bad since those yield pegs probably could have been achieved with much less buying of securities. Want proof of my assertion? Look at how ECB President Mario Draghi lowered yields in the peripheral euro zone bond markets simply by pledging to "do whatever it takes” to defend the euro. The ECB is the only major central bank that has fewer assets on its balance sheet than a year ago.

Today's Morning Briefing: The Final Frontier. (1) Into the darkness? (2) Five-year mission. (3) Central bank trekkies boldly go where no man has gone before. (4) The three scenarios again. (5) Escape velocity. (6) Debris field of weak PMIs. (7) Central banks flying into turbulent bond market. (8) Bernanke as Kirk. (9) Dudley more like Hamlet than Spock. (10) Cyclicals have come back in May, while defensive stocks have gone away. (11) “Star Trek Into Darkness” (+ +). (More for subscribers.)

No comments: